Deviating from a cap-weighted strategy leads to higher costs
The stock market is simply the sum of all transactions for shares of publicly listed companies, millions of which are conducted every day. Hour by hour, minute by minute, Benjamin Graham's voting machine is hard at work as market participants express their opinions regarding a company's future prospects through the price at which its shares transact. In a rational world, these opinions and the ensuing actions are based on an investor's knowledge and understanding of these firms. New information is combined with old, and prices fluctuate through a continuous auction-like process.
A company's share price that results from this system, when multiplied by total shares outstanding, forms its market capitalisation. Thus, as a company's share price appreciates, its market capitalisation and enterprise value grows, increasing in value relative to the overall market. With size comes benefits, including economies of scale, diversified revenue streams, and brand recognition. The winners of the competitive election process grow bigger and prosper, while the losers are relegated to the boneyard of capitalism.
Such a competitive process forms a simple basis for weighting stocks in an index. An index weighted by the market capitalisation of its constituents accurately reflects the market's opinion of each firm's value relative to its peers. The index is also self-balancing. The competitive pricing mechanism establishes a natural hierarchy that will alter a firm's weighting in proportion to its continuously changing capitalisation.
How Market Cap Impacts Investors
This self-balancing nature has a righteous implication for funds that choose to track such an index. Transactions are limited to adding or removing firms from the index. As a result, the fund's turnover ratio, a proxy for the percentage of assets that are transacted, is typically low. This reduced need to transact directly leads to lower costs. As the arithmetic of investment informs us, the less an investor spends the more she keeps, in the form of additional assets that can further compound in the future.
Investors that go against the natural market-cap-weighting process begin to stack the deck against themselves.
Deviating from a cap-weighted strategy usually increases the need to transact and leads to higher costs. This establishes a hurdle that must be overcome by the potential excess returns generated from said strategy. Some approaches may be more efficient than others. While it may be reasonable to estimate future transaction costs, it's incredibly difficult to know if an approach will generate enough excess return to justify the cost.
The Drawbacks
Market-cap weighting is simple, and the benefits are many. Why would you want to do anything different? Such a strategy is not a panacea for index construction. It has some drawbacks that need to be considered. Passive investors that become enthralled with the methodology may actually end up compromising what they set out to accomplish.
The assumption that market participants act rationally isn't necessarily true. History has shown that euphoria can take hold. Markets can become heated, causing the price of an asset to deviate wildly from its true underlying value. Just because a market values an asset at a certain price doesn't mean that value is correct.
Tulips, railroads, internet stocks and home mortgages have demonstrated that deferring to the wisdom of crowds isn't always a wise move. Owning a cap-weighted index could result in overweighting those stocks that have the richest valuations. Events such as these occur every now and then, but not with tremendous frequency. The idea of inefficiency is noteworthy, but alone not enough to reject cap-weighting.
Market-cap weighting carries further implications regarding two of the oldest factors of market returns. Companies with smaller relative market capitalisations, particularly firms that are of higher quality, have historically been associated with returns that beat a broad market index. But market-cap weighting, by definition, underweights these smaller companies and reduces their contribution to the overall index.
Value Investors: Look Elsewhere
Furthermore, declining share prices provide an important piece of information for value investors. As a stock's price declines, there is the potential for it to become "cheap" relative to its intrinsic value. Value investors attempt to exploit this sort of mispricing, and the approach has historically provided excess rates of return.
When the collective market turns sour on a company's prospects and cuts its price, a market-cap-weighted strategy will correspondingly own less of that stock. The contrarian nature of value investing – that is, buying what has declined in price – makes it incredibly difficult to be an effective value investor while using a cap-weighted strategy. The two just don't work well together.
Where does this leave funds that track cap-weighted indexes? The answer depends. If you're an investor looking for low-cost access to a given market, then a cap-weighted index is absolutely appropriate. Just make sure the investable universe is broadly diversified across regions, sectors, and stocks.
If you're a factor investor, you may have some additional things to consider: What strategies are going to give you the cleanest access to the assets that you want to hold? How aggressively do you want to go after those additional factors? It all comes down to how you want to express your opinion regarding a certain asset.
