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
