Comments on: Why do we invest in cap-weighted indices? http://blogs.reuters.com/felix-salmon/2010/07/08/why-do-we-invest-in-cap-weighted-indices/ A slice of lime in the soda Sun, 26 Oct 2014 19:05:02 +0000 hourly 1 http://wordpress.org/?v=4.2.5 By: DavidMerkel http://blogs.reuters.com/felix-salmon/2010/07/08/why-do-we-invest-in-cap-weighted-indices/comment-page-1/#comment-16535 Thu, 08 Jul 2010 21:16:31 +0000 http://blogs.reuters.com/felix-salmon/?p=4611#comment-16535 Cap-weighted indexes exist for one simple reason. They represent the average return for a dollar invested in a asset class or subclass.

Such a strategy has the advantage of being scalable: i.e. if the strategy was pursued to its fullest, all securities in the cap weighted index would be owned 100% by the index fundholders. No individual security in a cap weighted index is disproportionately affected by the creation or liquidation of index units. With non-cap-weighted indexes, securities that are scarce relative to their index weights get disproportionately affected by the creation or liquidation of index units.

Can you do better than a cap weighted index? Sure, but others must do worse for you to do better. Everyone as a group can’t do better; they will earn the cap-weighted index return less fees.

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By: OneEyedMan http://blogs.reuters.com/felix-salmon/2010/07/08/why-do-we-invest-in-cap-weighted-indices/comment-page-1/#comment-16513 Thu, 08 Jul 2010 14:48:36 +0000 http://blogs.reuters.com/felix-salmon/?p=4611#comment-16513 An equally weighted portfolio containing small and micro-cap stocks would in some senses be a much more crowded trade then the market weighted one as billions of dollars raced into small companies shares. That would drive up the prices of those shares quite a bit without any commensurate changes in their earning forecasts.

That doesn’t mean any one investor shouldn’t hold the equally weighted portfolio but does mean that everyone shouldn’t do it.

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By: wcw http://blogs.reuters.com/felix-salmon/2010/07/08/why-do-we-invest-in-cap-weighted-indices/comment-page-1/#comment-16511 Thu, 08 Jul 2010 13:56:55 +0000 http://blogs.reuters.com/felix-salmon/?p=4611#comment-16511 We index when we have no opinion. As noted above, CAPM is totally unnecessary to come to the conclusion that if we cannot add value, then we simply take a market exposure.

The better question is why we do not attempt to proxy for the large swaths of the market for which there are no easily traded instruments.

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By: dWj http://blogs.reuters.com/felix-salmon/2010/07/08/why-do-we-invest-in-cap-weighted-indices/comment-page-1/#comment-16509 Thu, 08 Jul 2010 13:43:42 +0000 http://blogs.reuters.com/felix-salmon/?p=4611#comment-16509 Belief in CAPM is sufficient, not necessary, to imply that this is optimal. CAPM doesn’t usually posit that all investors are equally risk-averse, though it does posit that everyone’s conception of “risk” is entirely captured by standard deviation of returns. It doesn’t require that one be able to short stocks, though it does require that the less risk-averse be able to borrow, to leverage up. I’m not clear on what you could mean by “the performance of the stock market as a whole” that would differ from the internal rate of return, i.e. the return on a market-cap weighted total market index, including dividends. (I’d also like to see you explain the distinction between an index and an average.)

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By: jabberwocky http://blogs.reuters.com/felix-salmon/2010/07/08/why-do-we-invest-in-cap-weighted-indices/comment-page-1/#comment-16508 Thu, 08 Jul 2010 13:43:38 +0000 http://blogs.reuters.com/felix-salmon/?p=4611#comment-16508 CAPM has nothing to do with it.

If markets are efficient and you’re not meaningfully different than the price-setting investor, cap weighting is ideal.

If markets are not efficient, it’s not clear what works, but cap weighting is cheap, tax efficient and diversified (by economics, not companies).

Fundamental indexing is a proxy for overweighthing small and value, which Fama French teach us is taking more risk for the hope of higher return.

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By: ayaga http://blogs.reuters.com/felix-salmon/2010/07/08/why-do-we-invest-in-cap-weighted-indices/comment-page-1/#comment-16507 Thu, 08 Jul 2010 13:38:29 +0000 http://blogs.reuters.com/felix-salmon/?p=4611#comment-16507 A correction: CAPM does not assume all investors have the same risk appetite. It assumes investors about standard deviation of returns as a measure of risk and return as a measure of reward (mean-variance optimal portfolios). But it allows for variation of risk appetite.

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By: Greycap http://blogs.reuters.com/felix-salmon/2010/07/08/why-do-we-invest-in-cap-weighted-indices/comment-page-1/#comment-16505 Thu, 08 Jul 2010 12:50:59 +0000 http://blogs.reuters.com/felix-salmon/?p=4611#comment-16505 Why do people buy cap-weight index ETFs? Retail investors buy them because that is the product available, if you want cheap, diversified exposure. Institutional investors want cap-weighting because that is how their performance is measured.

Why does the market supply mostly cap-weight? Well, the institutional market is important. Also, it is easier to supply the product in volume because the liquidity you need is well-correlated to cap weight.

In the age of cheap trading, it is within the reach of many individual investors to diversify themselves by buying a handful of individual stocks in equal weights – you get almost all the benefits of 500 names with 20 or even 12 – and rebalance somewhere between yearly and quarterly. But this requires discipline; once you touch individual names, it is hard to resist the temptation to start trading.

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By: TFF http://blogs.reuters.com/felix-salmon/2010/07/08/why-do-we-invest-in-cap-weighted-indices/comment-page-1/#comment-16501 Thu, 08 Jul 2010 12:04:48 +0000 http://blogs.reuters.com/felix-salmon/?p=4611#comment-16501 In an efficient market, more money would flow to undervalued stocks than to highly-valued stocks. Yet cap-weighted index investing forces the reverse. In the middle of the dot.com boom, the indices were shoveling new cash towards the technology sector for the simple reason that they were selling at high prices.

About 8% of the shares in each S&P500 company is held by index funds, and much more is held by portfolio managers who are too fearful of under-performing the index to deviate far from that core. This serves to increase market volatility by effectively decreasing the float.

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By: fxtrader14 http://blogs.reuters.com/felix-salmon/2010/07/08/why-do-we-invest-in-cap-weighted-indices/comment-page-1/#comment-16499 Thu, 08 Jul 2010 08:56:32 +0000 http://blogs.reuters.com/felix-salmon/?p=4611#comment-16499 Of course, if one is unhappy with market cap indices, they are a whole range of fundamental indices. The likes of GWA and RAFI offer a pretty comprehensive choice. Not all have products based on them, and many of those products are not as easily accessible as a tracker mutual fund or ETF – and cost more. And that assumes one can get past the fairly black box nature of those research outfits. (btw – fundamental indices are based on things like earnings, assets etc… essentially accounting numbers rather that market cap; the idea is that it avoids bubbles (backtesting (warning) shows they avoid the internet buble) as it focuses on the “real” economic performance rather than the mood swings of investors…)
What is interesting though, is that the last couple years performance of fundamental indices has been pretty dismal. They were overweight in financials as those companies were reporting really strong figures. Yet, those figures turned out to be pretty illusory when set in the context of the losses that followed. The problem is that accounting is not an exact science, it’s a moving set of rules, and different in various countries. All things equal, $1 of earnings from say china, UK or argentina should be treated equally (ie same rating) by investors – yet, it doesn’t happen. Fundamental indices try to address that, but clearly the accounting in those 3 countries will be different, hence that $1 will probablty turn out to be quite a different figure.

Still, if you’re a large pension fund with buying power, you can get a financial institution to create a custom product very cheaply following fundamental rules – that ought to reduce your porfolio overall risk.

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By: Rikh http://blogs.reuters.com/felix-salmon/2010/07/08/why-do-we-invest-in-cap-weighted-indices/comment-page-1/#comment-16498 Thu, 08 Jul 2010 08:18:04 +0000 http://blogs.reuters.com/felix-salmon/?p=4611#comment-16498 Easy in 2 ways: don’t have to follow 20 or 30 seperate issues and with 1 thing you get rid of all non Beta volatility. Last is not relevant in CAPM but of course for individual real investors not unimportant.

Not agree with the crowded point. You make it sound like a negative thing. Crowded means just more (size and/or quantity) will come. Assuming that it is iso investment in normal shares. And crowded likely means better and cheaper as it creates more competition. Only negative point could be that non index gets less popular, but with all new products this doesnot look to me a real danger.

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