If you want a white T-shirt, someone is always prepared to sell you a ‘better’ white T-shirt. For you sir / madam, may I suggest a Loro Piana white jobbie for a mere £1,795?1
How superior can this seventh wonder of capitalism be? Is Loro Piana’s T-shirt really 32,536% better than Next’s Basic Crew Neck, currently yours for just £5.50?
We grizzly frugalists may scoff – but we face a similar face-off whenever we’re tempted by smooth marketing sirens who insinuate that a plain market cap-weighted index tracker may not be all that…as they slide a reassuringly expensive alternative across the table.
If the market cap fits
Market capitalisation-weighted indexes provide the motive power that drives the majority of index funds and ETFs.
The S&P 500, MSCI, World and FTSE All-Share are all good examples of market cap indexes.
For ‘market cap-weighted’ read ‘weights its holdings by market value’.
Essentially, a market cap index ranks its constituents by the value of their tradable shares.
For example, the S&P 500 is an index composed of 500 leading US-listed companies.
The total market value of Apple’s shares as a percentage of the S&P 500 is currently 7.2%.2 So a market cap-weighted S&P 500 ETF allocates around 7.2% to Apple at the time of writing.
In contrast, Apple’s percentage share would be just 0.2% in an S&P 500 ETF that weighted each holding equally.
As it is, one of the smallest holdings in the S&P 500 is the FMC Corporation. That ‘if you know, you know’ chemicals manufacturer is worth 0.01% of the entire index.
The point is that the market has decided Apple is about 71,900% more valuable than FMC Corp right now. And that’s probably a better bet than any designer white T-shirt.
Accepting that the wisdom of the crowd is the informed choice is a bit like overcoming a Jedi trial en-route to investing enlightenment.
As real-life investing Yoda Warren Buffett puts it:
By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals.
Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb.
By “index fund”, Buffett is talking about any broadly diversified tracker driven by a standard-issue market cap-weighted index.
Ex-hedge fund manager Lars Kroijer expands on the theme:
A [market cap weighted] world index tracker enables you to let the global capital markets do the hard work of figuring out where your money will earn the best return – because that is what is reflected in the various regional weightings in a world tracker fund.
International capital has spoken. You can just enjoy the ride.
So what’s the problem?
The problem is it’s hard to believe there isn’t something better out there.
After all, market cap index trackers are the plainest, bog standardest, cheapest products you can buy.
They are that Next £5.50 Crew Neck T-Shirt.
They’re Aldi’s Everyday Essentials Baked Beans In Tomato Sauce. RRP: 60p per kg.
But surely Mr Organic’s Made in Italy Organic Low Sugar Baked Beans, Certified Non GMO & Preservative Free, Gluten Free & Vegan, Made With White Beans, Natural Herbs & Spices in a BPA-Free Tin (RRP: £49.88 per kg) are much better for you?
Okay, maybe that is insane, but Waitrose’s Duchy Organic Baked Beans in Tomato Sauce sure have a nice label. And likely a royal seal of approval. And they’re only £2.39 a kg. Or 298% more expensive than Aldi’s beans. Anyone for a blind taste test?
Alright, that’s a lot of talk about baked beans. But the reason I keep water-boarding this metaphor is because, like beans and tees, market cap index trackers are commodity products.
That is, such trackers are largely indistinguishable from others of the same type. They primarily compete on price rather than features. Many suppliers offer nearly identical products, leading to intense competition. And buyers can easily switch brands without significant consequence:
Spot the difference: MSCI World ETF 1-year returns – market cap weighted
Data from JustETF. 28 February 2025.
This is a great situation for us, the buyers. We’ve got oodles of cheap and well-made products to choose from.
But it’s far from ideal for the embattled investment firms bidding for our money.
If everyone’s happy with the market cap product then the suppliers can’t differentiate.
Instead they’re doomed to ever-eroding profit margins in the worst of all business worlds: eternal price war!
Trading up?
Cold logic dictates the financial services industry will instead try to upsell to us.
Hence, for a little extra, you can buy flashier trackers powered by:
- Fundamental / smart beta / risk factor indexes – which trim their sails to capture additional sources of return beyond traditional market beta.
- Equal-weighted indexes – designed to hold each stock in equal measure. The idea is to avoid the concentration risk that emerges when a market cap index is dominated by a very few companies. For example, the maker of Ozempic, Novo Nordisk, comprises 19% of the MSCI Denmark index.
- Other variants – for instance, ESG/SRI screened indexes. The sell being an index that’s ‘morally superior’ to those louche market cap benchmarks, up to their necks in sin stocks.
A taste of luxury
The alternatively-weighted index trackers are beautifully packaged.
You get a story – sorry, thesis – which explains why they may outclass the standard market cap solution.
Or perhaps solve some flaw that may – or may not – be inherent to market cap index design.
In the best case, the narrative is rooted in independent research that details why the alternative weighting has succeeded in the past and could do so again. Though that still doesn’t guarantee the resultant product is a good real-world solution.
A glossy back-test will also be included. This simulation always demonstrates the efficacy of the product – in an alternate historical universe where it actually existed.
But sadly many strategies that glitter in the data mine lose their lustre in the cold light of day.
Which brings us to the forward test…
How did alternatively-weighted indices perform in the wild?
A wide range of alternatively-weighted developed market indices have been available for many years now. Time enough that we can field test their potency versus our market cap baked beans.
Below’s a sweep of alternatively-weighted ETFs in the developed market equities category, benchmarked against an MSCI World market-cap driven ETF:
I’ve chosen the longest possible comparison period for this ETF selection: 4 September 2015 – 28 February 2025. Indices are based on the MSCI World stock universe where available.
The market cap product came third out of a field of 12.
Only Momentum and Quality did better over this period. The SRI-screened version of the MSCI World came close. The rest trailed by a considerable margin.
Quality beat the Market Cap ETF by less than 0.2% annualised. Neither here nor there.
Momentum won by almost 2% a year though. I’d definitely take that!
But we’re back to the old dilemma. Could you have predicted the winners of this race some ten years ago?
Indeed if you were investing at the time, did you predict it?
I didn’t. I was invested in Quality and Momentum via a Multi-factor ETF. However, that product also invested in Value and Small Cap, and it lagged the market by 2% annualised overall.
There’s no guarantee that Momentum will dominate the next ten years.
None at all.
Risk curious
There’s another way of looking at investment performance: through the lens of risk-adjusted returns.
Risk-adjusted returns measure an investment’s performance relative to the amount of risk taken to achieve it. A high return investment might seem very attractive versus a lower return option – until you consider their respective volatility.
To account for this, a metric like the Sharpe ratio helps you determine if an investment is delivering superior returns for the level of risk taken.
Rational investors are meant to prefer the investment with the best risk-adjusted returns. As opposed to just the investment with the highest return, irrespective of the psychological torture it may inflict along the way.
Happily, the website justETF enables us to calculate the Sharpe ratio for each ETF by comparing annualised returns against volatility.
The higher the Sharpe ratio, the better the risk-adjusted returns. In other words, the more return you get per unit of risk, as measured by volatility.
justETF presents the information as a pretty but hard-to-read heat map:
Really, we just need a table of Sharpe ratios. The highest number scoops the best risk-adjusted return.
Here then is the ranking for the top five ETFs in risk-adjusted terms:
| Underlying index | Sharpe ratio |
| Equal Weight | 0.88 |
| Market Cap | 0.87 |
| Quality | 0.87 |
| Momentum | 0.86 |
| SRI | 0.84 |
From this perspective we see the equal-weighted index is a nose ahead. Market cap comes in joint 2nd.
Momentum causes a teeny bit of unjustifiable pain in exchange for its extra 2% annualised return.
And once again, the simple market cap commodity product proved more than a match for the majority of its designer rivals.
Doubtless if we come back in ten years, the field will have reordered itself.
It could even be that the market cap ETF comes in last by that point.
You could hedge against that outcome by allocating some of your portfolio to the alternatively-weighted indexes – say if you’re worried about seemingly very high US valuations.
But remember that every pound you invest this way is a bet against the wisdom of the market.
The pros of market cap index tracking
Here are some additional reasons to retain your faith in market cap-weighted indexes:
- Simplicity – Market cap indices are easy to understand. The bigger a company is relative to the rest, the greater its presence in the index. That’s it, bar common sense rules to guard against over-concentration in the event we all go bananas and back SnakeOilSystems Inc to take over the world.
- Low costs – Broad market cap indices contain the most liquid equities and have low turnover. That’s why they cost so little. Alternatively-weighted indices are more expensive but promise superior returns. However while the costs are nailed on, the potentially higher returns aren’t.
- Performance chasing – Different strategies work best in different time periods. Something will be declared ‘hot’ based on recent performance. This reduces the likelihood of it outperforming in the future. Johnny-come-latelys swarm in, only to dump the funds when they fail to make ‘em rich. It’s always best to resist the temptation to jump on a bandwagon.
- Tracking error regret – How will you feel when your alternative strategy eats the market’s dust for five years straight? When returns soar we take it as confirmation that we’re as brilliant and blessed as we always suspected. But how happy will we be when our high-cost strategy is left billowing black smoke? That’s not a pain you have to feel if you simply invest in the market.
- Hard evidence – Twenty years is a reasonable amount of time to judge a strategy’s performance. Ten will do, five is barely acceptable. Anything less is irrelevant.
- No guarantees – The risk factors that power alternatively-weighted strategies are typically based on academic simulations that ignore real-world frictions. The excess returns discovered in theory are typically diminished in reality by:
– Diluted implementation: For example, long-only portfolios instead of long-short constructions.
– Overcrowded trades: There’s evidence that factor returns decline by about a third after discovery as investors bid up prices on newly sought-after stocks.
Or as John Bogle put it in The Little Book of Common Sense Investing:
I’m skeptical that any kind of superior performance will endure forever. Nothing does!
– High costs and taxes: Chunkier expenses have a greater impact on your returns, as we discussed.
Tried and tested
I say all of the above as someone who actually does invest in alternatively- and market-cap weighted trackers.
I’ve stuck with both for nearly 20 years but – as you can deduce from the graphs above – I’m very glad I didn’t abandon market cap investing.
I’ve no idea how the next decade will play out. Hence I’m content to maintain a position in both camps.
I still buy into the argument that alternatively-weighted indexes diversify my sources of reward, but I know it’s a risk.
And sometimes you just can’t beat plain and simple.
Take it steady,
The Accumulator
@The Accumulator,
Re the Cass Study and the shares chosen by monkeys. Given that any selection method is alleged to be better than market cap over the period under consideration, how come that every actively managed fund (especially small cap) in existence for 30 or 40 years has not outperformed the corresponding market cap-based index?
Either I’m missing something or there’s something wrong with the study or the way in which the results are being presented. Given the recent revelations in the 2010 Reinhart/Rogoff work, I’m minded to ask a few questions:
What am I missing ?
Has the Cass study been peer reviewed ?
Why hasn’t any prior study identified the superiority of the monkeys ?
Why hasn’t anyone (such as Vanguard) launched a monkey tracker ?
@Grumpy Paul — A big part of the reason will be fees and expenses. Fund managers aren’t slouches, but besides the theoretical underpinnings of why it’s so hard to beat the market (in short 50% must UNDER perform to make up for those who do better) its very VERY difficult to then overcome an extra 2-5% or what have you in costs.
@ grumpy old Paul I shared your skepticsm when I saw the monkey portfolios. I can see how the monkeys might over perform – just a very significant small cap tilt. What I can’t follow is how they managed to do this with better Sharpe ratios. Can anyone explain this?
The paper on the fundamental indexes just seem to confirm that there is a significant value factor in fundamental index construction.
What is I am sure now wrong is the attempt by some backers of Fundamental Indexes to claim that there is more to their out-performance than the value tilt ie that there is some inbuilt headwind that is intrinsic to cap-weighted indexes. I saw I nice quote from French (of Fama and French) saying that “Fundamental indexes are “just value funds for clients who don’t understand ratios”. Nothing wrong with a value tilt IMHO by the way. It is the stronger claims of the Fundamental Indexers which I think are wrong.
Thank you for posting the reasons why it’s a bad idea to jump into alternative index investing. I was contemplating to switch to fundamental index, and your post clearly laid out the pro of market cap index.
https://www.google.co.uk/url?sa=t&source=web&cd=1&ved=0CDkQFjAA&url=http%3A%2F%2Fdiscussions.ft.com%2Falchemy%2Fforums%2Fedhec-risk-forum%2Fdoes-theory-justify-fundamental-weighted-indices&ei=EKR2Ud_LFuik0AWd9ICIAg&usg=AFQjCNGQAx2KRk17I_yKis8UzqOGaGcuUw
This is a good recent summary of the academic literature on Fundamental vs Cap-weighted indexing debate
To be honest I think the precise asset allocation decision is not of paramount importance as luck will have a big part play in returns turn out to be, even over 30-40 years
I would weight these four factors pretty much in this order
– saving rate each year
– minimise tax
– minimise expenses
– asset allocation
For instance:
– if you spend 95% of your income it hardly matters what your asset allocation is, your savings won’t amount to be a % of what you earned in your working life
– if you are a higher tax payer putting money into a SIPP your contribution is near doubled straight away just because of the tax advantages of the SIPP
@Passive Investor,
Fascinating article which I’ve bookmarked for occasional rereading.
@Neverland,
Agreed. But there’s also maximising one’s income whilst working while maintaining an optimal work/leisure balance.
Not to mention choosing the right parents so as to win the ovarian lottery!
I sometimes think that we are at risk of spending too much time trying to chase the last .5% of return by fine-tuning passive portfolios, to capture value and small cap premiums etc especially when the latter are difficult to find in low-cost funds or ETFs in the UK. However, I can’t deny it makes for interesting reading.
@old guy
I agree with you about fine tuning passive portfolios. I think the best thing is to get the lowest level of cost with a good level of customer service and financially secure administrator
The extra 0.5% per annum from cutting fund expenses is certain, while all this stuff about chasing higher average real returns from different asset classes is very uncertain
0.5% fees saved on a £0.5m portfolio (which is what you will have to fund a comfortable retirement) is £2,500 a year
Assuming you are drawing down say 4% a year off that portfolio to live off, you would be taking out £20,000 a year
So screwing the fund expenses down gets you almost an extra month and a halfs income each year – its like being able to afford another holiday each year
I think I have answered the question about the monkey portfolios performance & Sharpe ratios.
The top 500 companies in the US have a total market cap of around $10 trillion the next 500 only have a market value of $1.5 trillion. The random picking monkey portfolios will therefore very disproportionately (compared with market-cap) weight the smaller companies. For example the 1000th smallest company (market cap about $130 million) will feature in the monkey portfolios as often as Apple or ExonMobile (market cap 3,000 times larger).
So the outperformance of the random monkeys is very likely to be a size effect. For reasons I don’t understand it seems to be well recognised that portfolios of smaller companies have higher Sharpe ratios. For example it seems from appropriate tracker funds that the following Sharpe ratios apply
5 yr Sharpe Ratio
S & P 500 0.3
Russel midcap 0.56
It will be interesting to see if the Cass papers attract professional / academic comment in due course
As far as simplicity and transparency are concerned, I would argue that equal weighting is even easier to understand that market cap weighting. Market cap based indexing was invented as a gauge of the prosperity of the respective stock market; mechanically turning a gauge into a ready-made investment portfolio sounds illogical to me (as long as my intention is to make money over the years rather than to follow the stock market for the sake of it).
Besides, equal weighting provides real diversification, while buying a market cap weighted index fund defeats the purpose of “investing in the whole market” in that respect: in the case of the UK virtually all of the money ends up invested in some 30 companies – so much for the whole market!
I am not aware of any equal-weighted FTSE100/350/all-share funds, so I am currently stuck with a 50-50 combination of VUKE and MIDD (I like ETFs for minor technical reasons) – which is, of course nowhere near equal weighting, but it still has given me both better real diversification and better performance than FTSE100, FTSE350 or FTSE all-share would have done. When it comes to S&P500, my money goes into the equal-weighted XSEW rather than into VUSA, even though the TER is higher by a whopping 0.21% – once again, better diversification (guaranteed) and better performance (so far).
@oldthinker
Well, a cap weighted fund is simpler as it only needs rebalancing when the index changes, which isn’t that often, whereas any other sort of tracker will need to rebalance at periodic intervals.
However, you are quite right to point out that instead of a fundamentally weighted portfolio that biases towards smaller companies, it is perfectly reasonable to get a large-cap and a small-cap tracker which together give something similar, even if the actual holdings are quite different.
Personally I avoid the FTSE100 as I don’t like its components. I have a FSTE250 tracker and see no need to have a piece of every pie. (Having said that, I do have a significant amount of ‘incidental’ large-cap exposure from my IT holdings.)
I haven’t dipped my toe into non-cap weighted funds, but I plan to the next time I add to my US exposure: I’ll probably go with the iShares minimum volatility ETFs. One fund I’d like to see is a volatility-optimised ETF that has a _high_ beta filter. It would be interesting to see if one could get a mix of volatile companies that still average out to give a low overall volatility. Of course, this would be swimming against the tide if the previously covered anomalies persist…
@Greg
I meant simplicity as defined by Monevator in this article, while you are referring to the ease of operating the fund, which is a different thing. The ease, or otherwise, of rebalancing is not of investor’s concern as long as TER remains reasonable. Simplicity is a different matter: try explaining equal weighting and market cap weighting to a child, and you will see :-).
Moe importantly, I like to understand why my money is going where it is going. Unlike you, I am broadly OK with the composition of FTSE100, so I am happy to be invested in, say, both Shell and ARM amongst others. However, I do not understand why for each £1 invested in ARM I need to invest £10 in Shell, which is what a cap weighed index fund would do on my behalf. The relative capitalisation argument does not convince me at all; as far as I am concerned, capitalisation was already taken into account when both companies got included in FTSE100. Investing into them £ for £ makes more logical sense to me, as doing this would give me better diversification, while I would still be investing in large British companies. It annoys me that I cannot do this simple thing with FTSE100; thankfully, an equally weighted ETF for S&P500 is available.
@oldthinker
With equal weighted ETF, I’m assuming that you want to tilt your portfolio towards small cap and value, correct?
The way that I built my portfolio is similar to yours, I’m using US listed ETF’s instead, with VTI (total market) and VXF (extended market, only mid cap and small cap). I have VTI at 17% while my VXF at 8% of my total portfolio, but I might gradually increase my VXF holding.
@oldthinker. The reason for investing in £10 in shell for every £1 in ARM is because that is how the market is allocating capital. Even if the market isn’t perfect (with bubbles, over reaction to unexpected information etc it clearly isn’t) it is a big step to say that you or anyone else or any fundamental valuation system can do better.
The reason many people justify fundamental or equally weighted indexes is to avoid the valuation errors in the market price. The trouble is that imperfect though it is there is a lot of information in the market price (eg about growth and risk). By deliberately ignoring this information ‘fundamentalists’ are saying that the fundamental valuations are a better judge than the market of fair value. I have seen no convincing empirical evidence that this is the case and the two main theoretical papers (arnott and hsu) have been heavily (and effectively in my view) criticised.
In all this it seems to me (to paraphrase Churchill on Democracy) that “the market price is the worst form of estimating fair value except for all the others that have been tried from time to time”
@dmdave. I am interested in your using US listed trackers as I was considering doing that to get a Value tilt. I was put off by the approx 2% currency spread at Hargreaves Lansdown which would be payable on all dividends too. I would be interested to know if you have found a better option?
@DMDave
I would say that I primarily want to diversify for real. Tilting towards smaller cap and value is a potentially useful side effect, but my primary intention is diversification across the companies included in my chosen indexes. The split does not have to be absolutely even, but I do not want to invest 50 times more into company A than into company B – this is not diversification; B can as well be ignored in this case.
@Passive Investor,
Yes, following the way the market is allocating capital is a strong argument for a passive investor (which I am). However, I am not at all happy with the degree of diversification achieved this way – the result looks too much like all eggs in just a few baskets. I sleep better at night knowing that I am properly diversified, and if I may take a performance penalty for this, so be it. So my strategy is not based on the assumption that equal weighting is likely to beat market cap weighting. In fact, I reckon that the results will be reasonably similar in medium to long term – but I will sleep better throughout.
I would quite like to use US listed ETFs but:
– Inside an ISA I would be hit with an extortionate currency conversion each time I bought or sold.
– Outside an ISA I would be hit with swinging taxes as they don’t have reporting status.
🙁
A friend claims to use a misogynist portfolio: if a woman joins the board, he sells.
@oldthinker. I am concerned about the over-concentration of FTSE 100 and just looking at current weighting HSBC is nearly 8% which is more than I am comfortable with (or realised). Still by the time this is diluted by FTSE 250 / foreign / cash and bonds depending on exact figures the weighting if HSBC in a whole portfolio may easily be only 2%.
The trouble with an equally weighted FTSE 100 portfolios is that the smaller constituents 0.04 % will with at 1% have a weighting of 25x the market weighting. This seems to be swapping one risk for another to me. …
@ Passive Investor
Sorry but I should’ve mentioned that I live in Canada. In a sense yes, by tilting your portfolio to have a more exposure to small cap, it’s a higher risk, but historically small caps do have higher rewards.
For example, small caps have the potential to become large caps and give out big rewards. Just look at Apple >10 years ago when it was on the verge of bankruptcy. At least that why I’m doing what I’m doing.
@ DMDave @ oldthinker I have a small value tilt for the reasons you say. The equally weighted fund seems an extreme (and possibly expensive) way of doing this. Also it may not achieve exactly what is intended in the sense that the S&P 500 or FTSE 100 don’t contain small caps. An equally weighted S&P fund is more of a tilt to ‘larger mid caps’ I guess.
That should say ‘small company’ tilt.
The alternative index approach sounds appealing but I can’t help feeling that the attention it’s receiving is at least partly due to its success in the past 10 years.
I suspect I’ll end up using both approaches ..
hmm. I am coming to the conclusion that the new fancy alternative index products are, bottom line, a strategy to entice us to pay higher costs to the providers. I know myself that I’m a sucker for ‘stamp collecting’ and can’t help but think ‘oooh yes, that looks shiny and new and interesting – I want some of that’. The hardest thing about passive investing (or indeed any investing) is maintaining the discipline to keep the strategy simple and above all to control costs. I totally agree with a previous comment about the marginal returns of all this tinkering with tilts. Best thing to do is to keep socking away money into the lowest cost tracker you can find and then ignore it…. (now, how can I make myself take my own advice??)
@vanguardfan. I am completely with you. The urge to ‘tinker’ is very very strong and needs to be resisted. Investment is all about knowing and dealing with your own psychology, I more and more realise. Wherever possible I use Vanguard too. The only thing I don’t like about them is that they are even cheaper in the US where to be fair they have huge economies of scale
Almost completely. I take a small cap tilt and would have a value tilt too if it was easily / cheaply available.
@Passive Investor
Swapping one risk for another is the name of the game – sadly, there is little else that can be achieved by our investment decisions. Being the kind of person I am, I would sooner put my trust in the law of large numbers than in the collective wisdom of fellow humans, so I feel that it is more important to be diversified than to be aligned with what the market as a whole is doing. Therefore, the concentration of FTSE100 in a small number of companies and sectors is of more concern to me personally than the remote chance of many smaller companies underperforming all at once (which is the only scenario where my relative overexposure to them would seriously hurt me).
You are, of course, right that diluting by FTSE250 alleviates the problem to some extent, but I see the resulting bimodal distribution as a poor substitute for roughly even allocation across the constituents of FTSE350, which I have no way of achieving at a realistic cost. Diluting by other asset classes also helps, but this is a separate dimension of diversification, and many other factors start coming into play here.
Although I don’t follow your strategy I can see the rationale for it. As I mentioned I hadn’t realised that HSBC is nearly 8% of FTSE 100 – I had it in mind that it was nearer 5%. For what it’s worth I keep FTSE 100 at 60 % of my UK shares but even so that leaved more than I would like in a single company. All the best
Apart from women’s handbags what other products or services do we buy more of as they get more expensive?
Intuitively, everyone knows that mkt cap tracking is sub-optimal. The fact that it works better than most active funds is not, in my view, a good justification for allocating capital by price.
The problem is that if everyone else is doing it the fundamental approach is drowned out by the competion. If everyone else thinks South Sea Shares or Enron is the place to be any fund that is underweight those gets crucified. Until the market corrects. But that could be five years or longer.
Surely the market cap of a company is, in part, simply a reflection of its size? HSBC has a bigger market capitalisation than other banks at least in part because it has much bigger assets than those banks and big operations in many countries. But does that make it any more appealing as an investment than a smaller bank?
Surely, the factors that influence whether a particular company is one that you want to be invested in (directly or indirectly) is the dividend yield that you expect to receive from it, the capital growth that you expect to receive from it and the level of risk that you might not receive what you expect. If the market changes its view on those three factors, it will certainly affect the share price of the company and therefore its market capitalisation, but it is only one factor.
If one bank has a market capitalisation 10 times bigger than another, then it seems to me this is not sufficient reason to put a 10 times bigger share of your portfolio into the first bank than the second (or to invest in a market weighted index fund that has this effect). I had never really thought about it before, but I’m starting to agree that it might be better to get the greater diversification that would come with equal weighting.
If there was any evidence that investment returns are higher for the companies with the biggest capitalisation, then market weighting would make more sense to me, but I understand that the evidence is that investment returns are, in the long run, higher for small capitalisation companies. I think it is true, however, that large capitalisation companies tend to be less volatile, so if you prefer to have lower volatility and accept a likelihood of slightly lower returns, market weighted index funds would make sense. Personally, that is not my preference, so the above posts have made me wonder about adjusting my index fund investments to improve my diversification.
@ivanopinion,
You have very succinctly summarised my conclusions on reading the above posts. But there are very few UK passive funds that are suitable for increasing diversification. As others have stated, FTSE 250 trackers help by skewing towards mid-cap companies but are presumably themselves market cap weighted. The HSBC FTSE 250 tracker has a pretty impressive 16 year record but did seem to drop more steeply than the All-share index in 2008/9 and August 2011. But if you have the temperament to accommodate that volatility, then that’s not a problem.
What I’d like to see are more funds like the Vanguard Equity Income fund but with lower caps on individual share and sector holdings and maybe a further set of variants tracking the FTSE 250. I realise that what I’m really talking about are further customised indexes and funds which track them. Such funds would have the following merits:
– low cost
– passive
– greater diversification
– tilt towards smaller companies
– tilt towards dividends
I’m a simple old geezer and am slightly wary of ETFs because I’m not confident of my understanding of them and am also wary of counter party risk.
Finally, common sense says that if it were that easy to beat the All-Share index, then far more active managers would do so consistently.
@ivanopinion,
You have very succinctly summarised my conclusions on reading the above posts. But there are very few UK passive funds that are suitable for increasing diversification. As others have stated, FTSE 250 trackers help by skewing towards mid-cap companies but are presumably themselves market cap weighted. The HSBC FTSE 250 tracker has a pretty impressive 16 year record but did seem to drop more steeply than the All-share index in 2008/9 and August 2011. But if you have the temperament to accommodate that volatility, then that’s not a problem.
What I’d like to see are more funds like the Vanguard Equity Income fund but with lower caps on individual share and sector holdings and maybe a further set of variants tracking the FTSE 250. I realise that what I’m really talking about are further customised indexes and funds which track them. Such funds would have the following merits:
– low cost
– passive
– greater diversification
– tilt towards smaller companies
– tilt towards dividends
I’m a simple old geezer and am slightly wary of ETFs because I’m not confident of my understanding of them and am also wary of counter party risk.
Finally, common sense says that if it were that easy to beat the All-Share index, then far more active managers would do so consistently.
I share the concern about the over-concentration of FTSE 100 in a few huge companies and for me this makes it sensible to over-weight the FTSE 250 in a market-cap-weighted index tracker.
The major disadvantage to equal weighting is that costs are likely to be significantly higher (equal weight charges seems to be o.2 % – 0.3 % over market cap weighted funds in US).
There will be periods when equal weighting out-performs and periods where it under-performs. But (I don’t think) there is any evidence or theory to prove convincingly that once size & value factors are accounted for the equally weighted will out-perform in the long run.
The cost differential is likely to be higher in the UK so why pay more in costs than necessary?
@ Grumpy – like the idea of a monkey tracker.
If you want to diversify your large caps then consider a global fund that will include the UK alongside US, Europe, Japan etc, such as:
Vanguard FTSE All-World ETF (VWRL) or a LifeStrategy fund. It’s about as simple a way to diversify as you can get.
If you want to tilt away from market cap then look at the PowerShares RAFI funds or a high dividend fund or the DFA funds.
http://monevator.com/uk-value-premium-funds/
Or split some of your FTSE All-Share allocation with a FTSE 250 tracker or something like the Credit Suisse UK Small Cap ETF (part 250, part AIM, part FTSE Small cap) as many here have suggested.
If you subscribe to the 3-Factor or 4-factor model then all but a few percent of equity returns are explained by a fund’s exposure to beta, small cap, value, momentum and perhaps another couple of return premiums. Hence why the monkey tracker (small cap) has a good chance of beating market cap and a fundamental fund (mostly value) has a good chance of beating market cap.
No magic, no trickery, if a fund is tapping into more sources of return then it should beat a market cap fund which only earns beta.
@Greg> I would quite like to use US listed ETFs but … outside an ISA I would be hit with swing[e]ing taxes as they don’t have reporting status.
Check out
http://www.hmrc.gov.uk/collective/rep-funds.xls
A lot of Vanguard US ETFs look like they are listed. VOO S&P500 tracker, for example, 0.05% TER.
https://institutional.vanguard.com/iippdf/pdfs/FS968.pdf
Matching the cusip number to the ETF ticker is a bit of a bear, though.
Another way to make the same point regarding market weighting would be to imagine if, instead of a FTSE 100 tracker, you had the choice of two trackers, the FTSE 10, based on the biggest 10 companies in the FTSE, and the FTSE 90, based on the next biggest 90 companies. For every £100 you have available to invest in the FTSE 100, would you really put £43 in the FTSE 10 and £57 in the FTSE 90? Because that’s effectively what is happening if you invest £100 in a FTSE 100 market weighted tracker.
I take the point about it being difficult in the UK to come up with a way of adopting a different split whilst maintaining a passive investment approach. I’m going to check out some of the alternatives highlighted above.
@ivanopinion
“For every £100 you have available to invest in the FTSE 100, would you really put £43 in the FTSE 10 and £57 in the FTSE 90?”
There are three or four reasons not to, but in my opinion only two of them are correct.
1) The FTSE 100 is as we have agreed is over-concentrated in the mega-caps (HSBC, Vodafone, BP etc etc). This can be easily overcome by taking a ‘total market approach’ and investing in FTSE All Share (which is roughly 80% FTSE 100, 16% FTSE 250, 4% smaller). The over-concentration can be further diluted by investing in foreign markets (of which the US is obviously much the biggest). For what it is worth I think this makes sense.
2)The second reason to deviate from FTSE 100 is to take a small cap tilt on the grounds that this will probably lead to greater returns (at the price of greater volatility). I do this to0.
3)The third reason which I think is misguided is to suggest that there is some intrinsic reason why market cap-weighted indexes are inherently ‘inefficient’. This is the argument made by Research Affiliates with their Fundamental Indexing approach. To my mind their arguments have been convincingly and mathematically been demonstrated to be wrong. (RAFI make a make a strong claim that their indexes offer much more than just a value tilt. They claim to be able to avoid an inherent arithmetically driven weakness in market-cap weighting)
4) The fourth reason (that I can think of) would be to take a value tilt either using RAFI or not. I would think about doing this but the danger is that you can end up actually being even more concentrated in very large stocks.
I think a lot of the hype over alternative indexes (fundamental, minimum volatility) is pushed on investors for the wrong reasons. The investment industry is extremely worried about market-cap index investing among private investors. It is the cheapest possible form of investing and with Vanguard charging 0.15% in UK and less in the US their profit margins are evaporating.
This is a very large driver indeed for the industry to come up with alternative indexes.
It seems very unlikely to me that the extra (?0.3-0.5%) cost of alternative indexes is worth the POSSIBLE extra returns. All the alternative indexes have sometimes under-performed market-cap indexes for very long periods on back testing and their returns going forward are likely to be less anyway. (There is always a back-testing bias, and the market is likely to erode future returns over time.)
I plan to stick with cheapest possible market-cap weighted indexes but to dilute out the FTSE 100 mega-caps by diversifying as noted.
Hi PI,
If we’re agreed that the returns from fundamental investing are value returns then there’s no need to rely on back-testing (though I appreciate that new fund ideas use this to make their case).
But you can go back as far as you like, using real data, to see that the value premium exists. A fundamental index may not be the best way to capture it, but we’re kinda low on options here. So far the market hasn’t snuffed out the value premium and there’s no way of knowing whether that premium will wax or wane in the future.
The evidence for the size premium is weaker than the value, so the diversification argument applies more strongly to value companies than small companies.
I completely agree with you that the motivation of the industry to dream up new ideas is based on profit margin, but not every new idea is bunk. Just 99% of them are 😉
I think we are basically agreed and (although I might can see I implied differently) I do agree with you that the value premium is likely to be persistent.
If Vanguard or iShares offered a World or Small Cap value physical index tracker, at a good price, I would put perhaps 10% of my stock portfolio in it. (Even so I would be a bit worried that I might not stay the course if there was a repeat of the late 90s bubble.)
My concern with Research Affiliates is that they claim that their recent (and back-tested) out-performance is about more than just capturing Value. I think this is to put it politely highly controversial and it has the effect of weakening investor confidence in market-cap weighted indexes which despite the noted disadvantages have some major advantages (eg very low turnover, representing the view of the capital markets etc).
This article by Kaplan from 2008 “Let’s not all become fundamental indexers just yet” explains it quite well
http://www.nxtbook.com/nxtbooks/morningstar/advisor_2008spring/index.php?startid=23
All best
Good article. Thanks for sharing. I’ve seen references to Arnott climbing down on his claims for fundamental indexing and admitting that in reality he’s just capturing the value premium.
I say ‘just’ – capturing the value premium is good enough reason for me to use fundamental indexing, though I can see why the earlier hubris puts you off the brand. I’d be happier if Vanguard released some of their broad market value funds over here. One day.
Using the FTSE All Share helps a little bit with overconcentration, but I don’t think it is a full solution. If 80% of the All Share is the FTSE 100, and 43% of the FTSE100 is the FTSE 10, then putting £100 into a FTSE All Share tracker is still equivalent to putting £34 into the FTSE 10.
I don’t really see investing in foreign markets as being a solution to this, because I tend to adopt a top-down strategy to allocating my portfolio. I decide first of all how much of my portfolio to allocate to the UK, versus North America, Asia, Europe, and emerging markets. But I still don’t want to put 43% (or even 34%) of my UK portion into just ten UK companies.
I have the same problem with using global trackers. The Vanguard FTSE Developed World ex-UK Equity Index fund is heavily dominated by US equities, because that’s where most of the world’s biggest companies are. 58% of this fund is invested in North America, but I don’t want to put more than half my portfolio in one region of the world. Fortunately, this is easy to correct by buying different proportions of regional trackers.
I’m not sure that the RAFI funds are a solution to overconcentration, either. I just had a quick look at the FTSE RAFI UK 100 fund and more than 50% of it is invested in just 10 companies, so it is even more over concentrated than a market weighted tracker. To be fair, I don’t think they claim to be an antidote to over concentration.
On the other hand, another recommendation made above was Dimensional. Their UK Core Equity Tracker explicitly sets out to underweight the large cap equities. This has a 35% concentration in its top 10 holdings, which is better than 43%, but still pretty high. I would really like to see someone like Dimensional take this a step further and produce a tracker with equal weighting in each of the FTSE 100 companies.
Then again, if you are just going to put 1% of your portfolio (or the portion of your portfolio that you’ve allocated to the UK market) into an equal amount of each of the 100 companies, then that’s a strategy that is much simpler and cheaper to operate than a market weighted tracker, because there would be no need to rebalance in reaction to swings in value of each stock. You might want to rebalance periodically, if some stocks fluctuate massively and become worth significantly more or less than 1% of your portfolio. But there is nothing magic about the 1% figure, so I think this could be fairly infrequent. This would mean that trading costs would be pretty low. I wonder how big your investment would have to be before it would be cheaper just to buy the underlying stocks yourself.
If you shop around, you can get trading cost down to about £6 per transaction, so buying 100 stocks would cost £600. Let’s assume you end up rebalancing 10 of them per year, so that would be 10 sales and 10 purchases, so a further £120 per year. Average cost over 10 years, £168. Even if you had £100,000 to invest in this self managed FTSE 100 equal weighted tracker, that works out at annual costs of 17 basis points, which is more than even some market weighted FTSE 100 trackers. You would think that a fund with the same strategy could get the annual costs down far below this.
By and large mkt caps refelct the underlying fundamentals of the companies. Even Fundamental Tracker funds have a large concentration in the big caps.
The reason is that the main driver of equities is dividends and the largest dividend payers are the big caps. This demonstrates that the business logic behind consolidation actually works.
It is just that in the short term they can be overshadowed by whatever is currently flavour of the month.
Since QE started 4 years ago grwoth stocks have been favoured at the expense of value stocks, as Buffet has so elonquently pointed out.
@ Ivan – The problem is how do you decide when an index is too concentrated? If you believe the market is putting too much store in America, what do you know that everyone else doesn’t?
Equal weighting just concentrates your risk in different ways.
Equal weighting was tried in the early days of indexing and was found to be problematic. High turnover and high costs.
Still, no point hankering after a fund that doesn’t exist. There are plenty of other ways to diversify as outlined above.
@ivan @accumulator
http://www.rickferri.com/blog/investments/no-free-lunch-from-equal-weight-sp-500/?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+RickFerri+%28Rick+Ferri+Blog%
Here is Rick Ferri making a similar point about equal weight today. May be of interest
@Accumulator – I accept there is no objective measure of when an index is too concentrated. But the FTSE 100 does seem to be quite extreme. The top 10 holdings in the Vanguard US Equity Index fund represent only 15% of the fund, compared with 43% for the FTSE100. So I’m ready to make the subjective judgement that the FTSE 100 index is too concentrated. So is the FTSE All Share, with 34% in the top 10 holdings. I’m not so worried about the S&P Total Market Index, which is what is tracked by the Vanguard US Equity Index fund.
And in relation to the market cap of the US market versus the rest of the world, I think this reflects many factors in addition to investors making top-down decisions about how to allocate their portfolio across the different regions in the world. For a start, many investors have a huge inbuilt bias to their home market. The UK market is approximately 10% of the capitalisation of world stock markets, but most UK investors have considerably more than 10% of their portfolio in the UK market. Even in New Zealand, most investors primarily purchase NZ stocks, although this is a fraction of 1% of world markets. Similarly, most US investors will have a huge bias towards the US market, regardless of its share of world market cap. Therefore, to some extent, the market capitalisation of the US market is simply a measure of the capital available for investment by US investors.
I accept that judgements about likely returns and risks of the US market versus other markets are part of the explanation of the market cap of the US market, and I would not presume to second guess the wisdom of the crowd on that. But I don’t think it is the only factor explaining why the US market is more than 50% of world indices and I’m not going to slavishly follow market cap as my only guide to geographic asset allocation. (I suspect very few of us do.)
In many ways, the US market is hugely diversified, but it is still heavily dependent on the fortunes of the US economy and if things start to go badly for the US, most US companies will be adversely affected and so the US market as a whole would perform worse. I don’t want to bet 58% of my portfolio on the long-term performance of any one country. (However, I will probably put more of my portfolio into this region than any other region, because market capitalisation should not be ignored altogether.)
I do agree that equal weighting (even if it were available for a UK tracker) has its own problems. I’m not sure I can see the need to rebalance quarterly, which is what Ferri says is done by equal weight trackers. Why not rebalance only when the weight of a stock has fluctuated by a given percentage over or under the starting allocation? This would cut costs considerably.
I take your point about other ways to diversify. Certainly, the fact that more than 7% of the FTSE 100 is HSBC should be more of a concern for the investor whose only investment is in the FTSE 100, in comparison with, say, someone who has most of their portfolio invested in other regions/countries.
Isn’t it reasonable to have a home bias, provided you expect to stay in your home country, because of the foreign exchange risk?
It may well be, but what I’m questioning is whether it is reasonable to let the market capitalisation that results from the home bias of US investors influence me (as a UK investor) to put 58% of my portfolio into the US market.
More ammunition for the debate
http://www.etfstrategy.co.uk/david-stevenson-on-smart-beta-etfs-including-high-dividend-etfs-and-low-volatility-etfs-45269/
Being influenced by the verdict of the market is at least as reasonable as trying to guess what effect ‘this factor’ or ‘that factor’ may be having – which is nigh on impossible. It may be less fun but it is simple and it is reasonable.
So are you saying you have more than 50% of your portfolio in US equities?
And only 10% of it in UK equities?
@acc @ivan.
I follow and would argue for a half way position. Foreign equities make sense because they offer diversification, some degree of non-correlation (though not enough when you need), access to more dynamic economies than the UK and I agree that ‘the wisdom of the market’ is not to be dismissed lightly.
The disadvantage is exchange rate risk. Over the long- term this is actually fairly low but the trouble for the near-retiree is that you could hit a major appreciation of sterling in say your last 5 years of accumulation / first five years of draw-down. If that happens it won’t be much consolation to know that ‘in the long run everything will be all right’.
The obviois compromise is to put 40-60% in the UK and the rest in non-UK markets. Hopefully this gives the best of both worlds.
All,
I didn’t realise that this debate was still continuing but interesting it sure is!
Having read all of the above comments, I’m still inclined to stick with simple market cap. trackers for the bulk of the equity assets within my portfolio but will, when I next rebalance, tweak it with a nod in the direction of value and small caps. However, I am aware that if this “nod” is, say 20%, of my equity assets, and has an out-performance of 2.5% (after additional charges), then the extra performance of my equity assets as a whole will have been enhanced by, you guessed it, .5%!
Regarding the weighting towards the US, I think I’d have to look at factors like the turnover, dividend, profits of US companies compared to the rest of the world to help decide how much exposure you feel is appropriate. Also we need to remember that a big chunk of US companies’ business is generated overseas so you’re not just betting on the health of the US economy. But, yes, currency exposure can be a risk.
Regarding the over-exposure to FTSE top 10 companies resulting from a market cap. tracker, yes it does mean that you get caught up in market bubbles but also, presumably, you also benefit from momentum. If there is a market bubble (anyone expecting that in the next 5 years?), then disciplined rebalancing between equities and other asset classes and between the UK and overseas equities will help reduce the impact of the bubble bursting.
I would argue that is possible to recognise when equity markets are in “bubble territory”, even at the time. The difficulty, is jumping off the bandwagon early, watching it carry on moving, and enduring the scorn of any acquaintances who know what you’ve done! Bubbles can last a long time with the most extreme case being the UK residential property market.
“Jumping of the bandwagon early” is of course not passive unless it happens as part of your passive rebalancing strategy. Which leads me to wonder whether limiting market sector allocation should also be part of a passive strategy and, if so, how it could be implemented for UK investors.
It’s a pity that also there aren’t FTSE 100 decile trackers (top 10, 11-20, 21-30 etc), even if cap. weighted, which would allow a passive investor to very simply restrict exposure to a hand full of elephant cap. companies as they see fit.
I’m deliberately not attempting to quantify anything (e.g. maximum sector exposure, maximum exposure to one company, maximum exposure to top 10 companies) because different investors would want different targets but I do feel there is a place for a variety of simple cheap cap. weighted trackers for passive investors wishing a greater level of diversification.
@ Grumpy – good thoughts. One of the things that’s becoming apparent from the debate on this thread is that we’re a bunch of very committed ‘passive’ investors who like to finesse. So I think we implicitly accept a higher than average level of complexity in our portfolios.
But think one of the great selling in of passive investing is its simplicity. Anyone worried about the concentration of the FTSE 100 or All-Share would be well served diversifying across the standard asset classes – international, emerging markets, fixed income, real estate, maybe commodities, maybe small cap and value.
After that you could overweight into a FTSE 250 fund. There is no real need to go any further except because you love it. As we clearly do.
@ Ivan – it’s tough to commit 50% of your portfolio to the US when there are all the asset classes above to fit in plus a home bias because like PI and PC I am concerned about currency risk.
I am 25% UK – diversified across market cap, small cap and value.
I am 50% international – same split.
But my market cap and small cap international funds are both 57% US and I don’t worry about it at all.
I’m well diversified across the asset classes and sources of return and what metric would I use to change the verdict of the market into a more rational decision?
As Grumpy says, if I could see a massive bubble inflating then I’d be prepared to take action, but it’s easier said than done. I wonder how many investors got out of Japan in 1989 or tech stocks in 1999?
http://www.thereformedbroker.com/2013/05/06/fundamentally-weighted-vs-cap-weighted-indices/ yet another article on cap weighted. v fundamental indexes
Dimensional has popped up on TD Direct.
http://www.ossiam.com/index.php/solutions/ossiam-etf-stoxx-europe-600-equal-weight-nr#
Thoughts?
TER of 0.35%. The best physical market cap index is 0.3%(HSBC) and the artificial dbx at 0.2%.
Its artificial.
Only started in May 2012 so no indication of how good the tracking is. Total of about £60 million so not promising for tracking economics of scale.
Nearly non existent volume but authorised participant should keep the spread low.
@all — The Accumulator has completely re-written and extended the original 2013 post here, but it’s still essentially the original on steroids so I’ve left the old comments intact. If something does read off in a comment, please check the date!
@TA
Thanks for the update. Intrigued to see that momentum is the only factor that’s really had an advantage over the last ten years. Still, I’m sure your multi-factor holding will have its day!
Minor typo alert: it’s Loro Piana. Not that I’m in the market for such an extravagant item of apparel. 🙂
Thanks you @TA for such an excellent review. No plug for your new, competitive and rather fetching branded attire?
Very interesting work, and I get more plain white tee (Asda) every year. (Although a natty DNFS one is now in my top drawer)
The comparison table of factor weighted funds seems to have a lot of area left of the dotted line unfilled in total, some of which must be accounted for by fees greater than a plain vanilla market cap fund, in a zero sum game – The question that comes to mind and is probably incalculable, is for funds that under perform, what did their “anti” fund do? Did a “ciggies, booze, guns and oil” fund, not that it exists, wallop an ESG fund for instance? It might not matter to the investor, but it might shed light upon the state of the world.
All things being cyclical, I look forwards to next decades results.
Thanks TA.
JimJim
An interesting read. But the period for the comparison of alternate-weighted ETFs is only 10 years and it is only one 10 year time period. Surely, even looking at one period, the initial conditions e.g stock market, stock market concentration and economic will have an influence on which weightings are likely to outperform.
A search for a chart showing a history of the market cap of the top 10 S&P 500 stocks as a percentage of the index led me to https://osbornepartners.com/the-sp500-concentration/.
The chart therein shows an ominous parallel with 1980 and 2000. I also note that the Atlantic Fed GDPNow tracker has cut its forecast for 1st quarter GDP growth from 2.3% to -1.5%.
I’m considering getting an equal-weighted tracker to reduce exposure to the top 10 US stocks. But it would be inconsistent with my long-term aim to hold as my stock market 50% VG LS60 and 50% HSBC Global Strategy Balanced exposure in my dotage – I crave simplicity.
A very timely post, thank you!
Tim Hale, who’s model portfolios I follow, advocates for a tilt to developed value and small cap. And actually, reading this article, has strengthened my conviction to keep holding. Sure, they could be a drag, but they also help with the queasiness around the US/Mag7, and they could be the next risk premia to perform. I’ve got plenty of exposure to momentum through my market cap weighted tracker, so some allocation to value and small cap, I’m comfortable with.
And for those who want their money to do something different than just make as much money as possible?
In the light of recent news, I’m toying with the idea of divesting from the US entirely. If only big companies were not mostly global entities. And I really don’t want any part of anything to do with Musk.
I like the idea of ESG but don’t like the criteria they use on closer inspection.
My naughty active investing is partly in clean energy businesses of various sorts, because that’s the future I want.
Am I being naive? Should I be more hard-nosed and businesslike about it?
Read a report from Kepler today which quoted Philip Chandler, CIO @ Schroder IS, who said “just nine tech stocks (the Magnificent Seven plus Broadcom and TSMC) account for the same weighting in the MSCI ACWI index as all the stocks in Japan, the UK, Canada, China, Switzerland, France, India, Germany and Australia put together.” and that he worried that passive investors “are making a very active decision when they invest in a market-cap-weighted index fund today”. Though I suppose he has to support an active stance?
I’m using the Invesco RAFI AW ETF instead of market cap AW.
@Harry
Re… “… Though I suppose he has to support an active stance?..”
Well, yes, he would say that, wouldn’t he. ( Thank you, Mandy Rice Davies, RIP).
Thing is, those tech stocks are absolutely unlikely to be forevers as the top stocks in market capitalisation. Have a look at the S&P 500 components of 30 or 40 years ago. Who remembers IBM, Univac, Honeywell, Burroughs, Hewlett Packard etc.. , now ?
@Alex – If you’re providing seed funding to a clean energy start-up then you’re making a difference. If you’ve ripped out your gas boiler and replaced it with a heat pump, and bought an electric car, and are powering both with genuinely green energy, you’re making a difference.
But the evidence I’ve read leads me to believe that buying existing shares in an ESG index isn’t moving the dial. Though I guess it makes people feel better. Much depends on your objective, even more depends on exercising influence effectively.
@cm258 – yes, I agree. I’m happy to remain diversified across market cap and risk factor strategies. If nothing else, it helps me burnish my “not chasing performance” credentials. Holding my multi-factor ETF immunises me from that 🙂
@Grumpy – absolutely right! We only have a decade or – for the oldest ETFs – about 15 years worth of actual data. Everything else is a backtest.
My point isn’t that there’s anything intrinsically wrong with alternative indexes – though they almost certainly won’t perform as well as their academic progenitors – my point is that the humble market cap fund is still a design marvel.
I do think it’s significant that the risk factor ETFs have largely fluffed their first decade or so in the wild. Have the factor premiums been squeezed out? Has Big Tech killed Value? Have they just underperformed for 15 years, which was always a perfectly plausible outcome? Narratives abound but we just don’t know and I think we should invest like it. (PS – I know you do.)
@JimJim – heh, was intrigued by your sin stocks fund idea (wanna go into business?) so I just googled it. Turns out the Americans have you covered. VICEX and VICE fill the niche 🙂
Re: other anti-funds, these pairings come to mind:
MSCI Small Cap vs MSCI World
MSCI Momentum vs MSCI Value
@2 More Years – Haha. That did make me laugh. What can I say? I think the Monevator tees will generate high returns – interpret that as you will!
@Curlew – cheers for typo spot! Just checked my original copy. Spelled correctly! Just sayin’ 🙂
It’s difficult trying to predict the future relying only on the past.
Thanks for the update. Any thoughts @TA on the Mike Green et al passive broken conjecture? Links to research on this under my comment #11 back on 20th Sept last year – found here:
https://monevator.com/passive-investing-edge-and-market-efficiency-winners-need-losers/#comment-1836533
[Green’s latest “Yes I Give a Fig” substack post also gives some more details.]
@TA – Could be wrong (often am) but looks like your link for the Beans is for a pack of 12 hence the price. But weirdly the good news is to buy 12 single tins its a bargain like getting an investment trust discount.
@The Accumulator
One compelling argument for cap weighted indices was impressed upon me by an interesting Morgan Stanley research article several weeks ago in Weekend Reading.
Namely that overall returns of equity indices are dominated by a small percentage of winners (like Apple, as you pointed out) while most are at best lacklustre or just outright losers.
For me, this is a killer argument against equal weighting or other selection methods – at least in equities markets; the winners need to be let to run to capture those gains long term and equal weighting actively operates against that.
Is there a post on good multi-factor ETF update since 2015? maybe i missed it or bad at searching.
I don’t think that there has been since then @ramzez.
I suspect that Momentum (aka Winners Minus Losers – or WML in factor jargon – in the same vein value is High Minus Low/HML – although all UCITS Momentum ETFs are long only AFAIK) has outperformed here as cap weight is just a diluted form of momentum, and if you like cap weight then you have to like momentum IMHO. There really isn’t an intellectually honest cap weight purist ‘option’. Buying regardless of price (cap weight tracker) just means accepting both the direction and the impact of fund flows, which is essentially, in practice, what a momentum strategy does but with a shorter lag/more rebalancing and with a more explicit mandate.
Another (better IMHO) way of thinking about a market cap fund is that it holds an equal share in all the companies in the index*. So a world index tracker might hold 1% of Apple, 1% of Microsoft, 1% of Tesco, 1% of BP, 1% of Gregg’s, etc. Right down to the size cutoff point for the index. This means that the tracker fund does not have to buy and sell shares due to price changes. If Apple shares double in price and Microsoft shares half no trading is required as the fund still holds 1% of each. The values of the holdings change, but the proportion of each company remains in balance. This is great from a trading costs point of view. Compare that to a momentum fund where the portfolio has to be regularly churned, buying shares that have recently risen in price and selling those that have fallen. There are similar issues with other factor funds, although others such as quality or value can still hold by market weight, just as a cap weighted tracker does, so typically they don’t need to churn quite as much as a momentum fund.
I don’t accept that a cap weighted tracker is a momentum fund, which is an idea that has been doing the rounds recently. It is entirely market neutral.
* This is not quite true as a free float adjustment is applied. For example if company A holds 10% of company B, then only 90% of company B shares would be considered investable.
@Naeclue #75: in principle what you say is correct but less so in practice.
Over time, cap-weighted indexes tend to favor companies with strong fundamentals (e.g., earnings growth), which aligns with the concept of “fundamental momentum” which ultimately feeds through to pure price momentum.
Market-cap-weighted and momentum funds share similarities due to their inherent exposure to momentum factors: market-cap-weighted indices naturally allocate more weight to stocks that have performed well, as their market capitalisation increases with rising prices. This creates a “momentum tilt,” where outperforming stocks gain a larger share of the index. Both strategies tend to favor stocks that are rising in value, reinforcing their positions in the portfolio. This aligns with momentum investing, which capitalises on trends in stock performance.
Optimisation in capitalisation-weighted index tracking ETFs makes them more similar to momentum funds by amplifying their natural momentum exposure through adjustments. Capitalisation indices inherently overweight stocks with rising market caps, which are often the recent outperformers. Optimisation techniques can enhance this effect by emphasising stocks with stronger performance trends, aligning them more closely with momentum strategies. Optimised trackers may rebalance more frequently or use algorithms to refine stock weights based on recent performance metrics, further increasing exposure to stocks exhibiting momentum characteristics. Also, optimisation often incorporates measures like covariance matrix estimation to manage risk while maintaining exposure to high-performing stocks, similar to the methodology used in momentum index construction.
Timed our whilst typing. Finally optimisation excludes the smallest cap weights leading to the largest cap firms having an increasing share of the index over time. This is why index concentration has gone hand in glove with increasing passive share IMO. This creates a momentum effect of its own for the mega caps at the top of the index weights.
@klj – It is a 12-pack but I quoted prices per kg not per tin. I hope one of our more minted readers tries them and reports back. Bill Gates says it’s all the same burger, but has he tried these beans?
@Where Are All The Sheep – it’s a good point and must ultimately be the source of the market premium. That said, market leaders historically falter and are replaced over time, so we bear the cost of their failure too.
@DH – I haven’t read it. What are your thoughts?
@TA: it’s worth reading those links.
There’s serious academic research into the Inelastic Markets Hypothesis these days and, whilst Green himself isn’t a part of that (he’s a money manager and blogger, not a researcher), it is notable that he is not saying that active is good and passive is bad. He actually says invest in passive cap weight for equities as active as a group can’t compete because of those issues. But he does see the situation as long term unstable. And he did make a couple of hundred million off of the 2018 Volmageddon trade on a $250k outlay for Thiel.
So I think it’s worth taking what he says seriously, as does Barry Ritholtz, who is both a sceptic of the IMH and of Green’s analysis, and is also a major proponent in the US of the benefits of cap weight trackers:
https://ritholtz.com/2024/08/transcript-mike-green/
@Naeclue, @DH:
Not to forget the effect of new money!
“I don’t accept that a cap weighted tracker is a momentum fund, which is an idea that has been doing the rounds recently. It is entirely market neutral.”
Well if momentum is defined as buying stocks that go up and holding them and selling stocks that go down – then an index fund is a form of momentum investing. The fund buys stocks when they reach a sufficient size ie mkt cap ie price and holds them as they maintain that size. The fund sells stocks that drop below a certain market cap ie price.
Hence, momentum.
innit?
@Naeclue, @geezah: some of this is a question of definitions. How strictly do we define indexation and cap weights? What exactly do we mean by momentum? Which definition should be used and why? This quote from Lewis Carroll’s Through the Looking Glass resonates: “When I use a word,’ Humpty Dumpty said in rather a scornful tone, ‘it means just what I choose it to mean — neither more nor less.’ ‘The question is,’ said Alice, ‘whether you can make words mean so many different things.’ ‘The question is,’ said Humpty Dumpty, ‘which is to be master — that’s all’.” IMHO momentum is not a risk factor in the original Fama French sense. It is not separate and distinct from other factors, but a way timing other factors based on price performance. It causes expensive/ cheap/ large/ small companies to be brought at some times and then sold at others. It is an approach which is factor agnostic, not the application of a factor per se. In this way it shares much with cap weight indexation. Personally, I would argue that momentum and cap weight approaches are not just somewhat parallel, but overlapping.
Note recent years strong correlations of S&P 500 capitalisation and momentum weight indices:
https://open.substack.com/pub/marketlab/p/the-cult-of-momentum
They’re either increasingly structurally coupled now, or one can/ should expect something of a breakdown in correlation and a mean reversion in covariance.
I respectively mention that 10 years is simply too short a time period to deduce that weighting by market cap is the best way to invest, especially as it covers a period where there have been strong flows into market cap weighted indexes, which has pushed their valuations up to high levels, both in absolute terms and relative to other investment approaches. Data covering 100+ years (during most of which there were not strong flows to passive market-cap weighted funds) suggests that weighting according to size is a distinctly average strategy, especially when starting at current valuations. An investment biased towards fundamentals/value has a far more stable starting point today.
I have just posted the following comment on a recent Fireside chat about the current dangers of investing in a global market cap weighted fund, but I think it would be useful to add here. I hope it helps a few people:
I really enjoy these fireside chats and am very grateful to Monevator for producing this content.
One key point I’d like to raise is the large allocation to global market cap-weighted index funds in Rich’s portfolio. While I agree that low-cost, rules-based global investing is sensible, I believe there are better alternatives given today’s market environment.
I’ve been an investment manager for over 20 years, and for most of that time, I advised friends to invest in global market cap-weighted index funds. However, valuations are now so stretched that I no longer give this advice. Fundamentals simply do not justify current prices. I suspect the relentless shift from active to passive investing—most of which follows a market cap approach—has contributed to the overvaluation of large stocks. This trend cannot continue indefinitely. Even a slowdown in passive flows could lead to underperformance in large caps, something we’ve already started to see in recent weeks.
A global market cap-weighted equity index is overwhelmingly driven by large U.S. equities, which are the most overvalued segment of the market, regardless of which valuation metric you use. Historically, the S&P 500’s starting Price-to-Earnings (P/E) ratio has been a strong predictor of 10-year returns. While P/E has little correlation with short-term market moves, its relationship with long-term returns is significant. Today’s forward P/E—based on optimistic earnings projections and record-high profit margins that are vulnerable to decline—suggests that future returns will be weak.
GMO’s latest 7-year forecast predicts annual real returns of -6% for U.S. large caps under normal interest rates and -2.9% in a low-rate environment. Even after the recent market dip, expected real returns remain negative. This isn’t just a possibility—it’s a strong likelihood. The precise timing is uncertain; the decline could happen swiftly, gradually, or after another period of gains. But the risk is clear.
Many investors—especially those following Monevator—have enjoyed excellent returns over the past 15 years using a market cap-weighted approach. However, I fear they are sleepwalking into a decade of low or negative real returns. There is another way.
For those who prefer a single global fund, my top choice is the Invesco RAFI All World 3000 fund, but any global fund with a value tilt should outperform a market cap-weighted alternative. While even value stocks aren’t cheap, their fundamentals suggest significantly better odds of positive real returns over the next decade. A slightly higher expense ratio is a small price to pay for potentially much stronger returns.
I understand why sticking with a market cap-weighted fund feels safe—especially when most investors are doing the same. But will failing conventionally be any comfort if your portfolio suffers significant losses, forcing you to rethink retirement plans?
If global cap-weighted index funds deliver the poor returns their valuations suggest, don’t say you weren’t warned.
@Mike — All fair comment but the trouble is it that most of it could have been said for the past few years. That’s always the trouble! 🙂 Eventually it’ll most likely be right.
I addressed some of these issues in a post last March:
https://monevator.com/what-to-do-if-youre-queasy-about-the-us-stock-market-members/
Looks like the Nasdaq is still 5% ahead of where it was when I posted that, even after the recent correction.
Small beans if we do have a proper crash of course, but as the Spartans once said: if…!
I’d very much endorse @Mike’s point on 10 years being too short. McQuarrie’s work shows how even the data for the S&P 500 from 1957 and the S&P 90 from 1928-1957 cannot be relied upon as representative of the overall historic US equity return, as just taking the analysis out to the 19th C gives a different picture.
Likewise, foreign market data is different to the US in terms of their ERP etc.
Moreover, even if we did have say a 1,000 years of market data for global equities, it might still mislead us, as this interesting discussion from 2017 elaborates:
https://abnormalreturns.com/2017/06/06/finance-blogger-wisdom-1000-years-of-market-data/
I think, based on what I can recall, that I’m right in saying that over the past half century the equal and cap weight S&P 500 have had similar overall returns (statistically speaking) but with major variations, not just from year to year, but also from decade to decade.
Cap weight approaches might continue outperforming as they have in the US since after the GFC.
But fundamentals in US large caps do look quite stretched on most measures – albeit that one could come up with many reasons (and many people have indeed come up with many reasons) why this could be justified, some of them quite plausible sounding, though perhaps not correct.
Personally, I’m guessing that the rise of passive is starting to have some degree of self reinforcing aspect to it in the large to mega caps space in at least the US; and that, if this is a real thing, then it could turn out to be either good or bad for the 5 to 10 year returns of US large caps, depending upon whether it then either further pumps up marginal prices or instead destabilises market dynamics through more volatility etc.
If net flows should ever structurally reverse due to demographics (with pension drawdown exceeding new money into the market) then – should passive share continue to rise, and if passive flow is having an effect on valuations; any correction to prices to reflect the underlying fundamentals could be more sever and longer lasting than in the counterfactual of a ‘no passive’ world.
But there’s a lot of “if”s in there. I give it some credence, but the theory makes plenty of assumptions.
@Mike – your post is an excellent counterpoint but…
The point of the post wasn’t to say that market cap investing is the best. Just that it’s a perfectly reasonable way to invest despite the lure of alternative approaches. Hopefully you’ve seen enough on Monevator to recognise that we don’t think 10-yrs is a long time. But it’s the only period we have for risk-factor fund performance vs theoretical long/short portfolios etc. Again, the point isn’t that the last 10-years definitively proves that market cap funds win. It simply demonstrates they aren’t second best.
The arguments you make now are why I split my portfolio 50/50 between market cap and risk factor indices over a decade ago.
That is, the market was overvalued, expected returns for the US were low etc.
I maintain that split for all the reasons you posit, because it improves diversification, because I don’t know what will happen.
I keep an eye on the p/e ratio (though it’s explanatory power is less than 50%) and on expected returns (though they’ve been predicting poor US returns for a decade) and I know that one day your warning will come to pass. The question is when?
More food for thought on market cap weight tracking with the S&P 500 in particular:
https://open.substack.com/pub/danielxperis/p/dr-frankenstein-would-like-a-word