The Pros and Cons of Market Capitalization Weighted Indexing

How would you describe the ideal investment strategy? And no, “buy low, sell high” doesn’t count. Personally, I would describe the ideal investment strategy with these six characteristics:

1) diversified

2) cheap

3) Tax efficiency

4) Has tons of capacity

5) Works well in the long run

6) Can be well used by investors

I would say that market capitalization weighted indexing meets all of these requirements. But while there’s a lot to be said for letting Mr. Mercado do most of the heavy lifting for you, there’s no guarantee that there won’t be times when you question the wisdom of Mercado and his decision to hitch his car to your every whim. Like any sound investment strategy, indexing won’t feel ideal at every turn in the market cycle. And the best attributes of indexing aren’t necessarily universal, especially as indexing has gone from broad market benchmarking to putting together lists of stocks that may or may not have anything to do with the topic of the moment, from artificial intelligence to Generation Z. Here, I’ll delve into the pros and cons of market cap-weighted index funds in more detail.

free lunch

Economist Harry Markowitz is credited with coining the concept that diversification is the only free lunch in finance. If diversification is a free lunch, then low-cost total market index funds are an all-you-can-eat buffet lunch. These funds hold as many securities as they can within their respective investment universe and weight them according to their current value. As an investor, you can’t cast a wider net and you can’t do less work. Indexers are freeloaders. They don’t bother lifting a finger trying to figure out how much something is worth. They leave that to the market.

But not all indices are broad. The narrower the index, the less likely investors are to enjoy the full benefits of moving alongside a benchmark index. This is particularly important in less liquid markets such as high yield bonds and bank loans. Because index funds in these corners of the market have to put a premium on investability and liquidity, they often miss out on some of the richest seams in the investment opportunity set. These are areas where investors are often best served by smart active managers.

Letting the market decide how to weight positions can also be a bad idea, at least sometimes. In the go-go days of the Japanese stock market of the late 1980s, the MSCI EAFE Index at one point had 44% of its portfolio invested in Japanese stocks. In the first quarter of 2000, the S&P 500 had 35% of its portfolio connected to the bubbling tech sector. With the benefit of hindsight, we can say that this was bad for the brand of market-cap-weighted indexing. In fact, the bursting of the tech bubble was the event that launched 1,000 alternatives to market cap weighting.

Less is more

Market-cap-weighted index funds typically don’t charge much, if anything. From an investors perspective, this is ideal. After all, in the words of the late Jack Bogle: “In investing, you get what you don’t pay for.” Vanguard Total Stock Market ETF VTI is the world’s largest index mutual fund’s publicly traded share class, with over $1.3 trillion in assets. It charges an annual fee of 0.03%. But VTI’s market price performance from its inception in May 2001 to March 2022 lagged its spliced ​​index by just 0.01% per year. This was thanks to a combination of smart portfolio management and securities lending income. For almost nothing you can get, Vanguard has been delivering US stock market returns to investors for decades.

But why pay anything? In August 2018, Fidelity launched a suite of zero-fee index mutual funds, including Fidelity Zero Total Market Index FZROX. As the name of the fund implies, it charges nothing and has no minimum investment requirement.

The proliferation of low-cost index funds has been a boon to investors. But as fees have gotten closer to or near zero, their impact on the long-term returns of these funds has diminished. For example, from the inception of the Fidelity Zero Total Market Index in 2018 through March 31, 2022, it outperformed VTI by 0.10% on an annualized basis. Only a small part of that outperformance can be explained by the differences in the two funds’ fees. As expense ratios decline, subtle differences in index methodologies, portfolio management practices, and stock lending programs will have a much greater influence on the long-term returns of seemingly identical index funds. .

tax season

Market capitalization weighted indices tend to have low turnover. All things being equal, less billing means less taxes in the form of taxable capital gains distributions. Broad market index funds have generally been much more tax efficient than their active counterparts. But that’s not always the case and can only be partially attributed to their relatively lower turnover. There are many index mutual funds that have imposed large tax bills on their investors over the years.

The ETF wrapper adds a layer of protection from the tax man. Facilitating fund redemptions by withdrawing securities in kind protects ETF shareholders from the potential tax consequences of others’ liquidity needs. But this is an attribute of the ETF wrapper and not broad market indexing.

Unlimited

Broad market indices don’t hit capacity constraints the way an active manager operating in the small-cap value space might. Sweeping across the full spectrum of stocks in your investment universe and being price agnostic means that broad-market index funds aren’t going to suffer asset bloat like an astute small-cap stock picker might. As such, investors need not worry that the next dollar added to their total stock index fund is going to hurt portfolio managers’ ability to deliver. Mr. Mercado is happy to get that dollar, and the next, and the next.

But what about the effect of the torrent of flows into index funds? Should investors be alarmed about programmatic buying by hordes of retirement savers? The only honest answer I can give to this question is: I don’t know. But I do know that people have been throwing mud at indexing since day one, calling it “un-American,” “worse than Marxism,” blaming it for stifling IPOs, and more. And all these snubs and “dog wagging tail” arguments aren’t new. Long before index funds were the “queue,” market professionals worried about “the state of mutual funds.”

I am not convinced that the growth of indexing has been detrimental to markets or investors. If anything, any degradation in the efficiency of the markets has likely been more than offset by the untold billions index investors have saved in fees, transaction costs and taxes. If the day ever comes when the next dollar allocated to an index fund sends the markets out of whack, I have faith there will be ample incentive for market participants to step in and fix things. I have faith in the ability of the markets to heal themselves, mainly because their ill health presents opportunities for profit.

just average

By definition, broad market index funds are average. In any given year, about half of the active funds will do better and about half will do worse. But over longer periods, being average can lead to better-than-average results, sometimes much better. Why is this? First, because the fee advantage of index funds accumulates over time. Second, because most active funds don’t make it.

The data supports this. Morningstar’s 2021 Year-End Active/Liability Barometer showed that over the decade to December 31, 2021, only 26% of actively managed funds available at the start of that 10-year period managed to survive and outperform their peers. average indexed. Over longer time horizons, the advantage of index funds only increases further. Sometimes being perfectly average is perfectly fine.

relative predictability

An ideal investment strategy is one that you can stick with. But hanging hard is, well, hard. I’d say it’s easier to sit still if you know exactly what you’ve signed up for.

Relative predictability is a phrase attributed to Jack Bogle. The idea behind the phrase is that investment strategies may or may not work as one would expect. In the case of index funds, they work more or less exactly as you would expect. If investors’ expectations are properly calibrated from day one, I think they are much more likely to stick with their strategy through thick and thin. It’s hard to imagine a strategy that comes with clearer expectations than indexing.

Don’t meet your idols

There is no ideal investment strategy, not even a broad market capitalization-weighted index. Every single strategy that has ever existed, from the Nifty Fifty to whatever the Renaissance Medallion Fund does, has had strengths and weaknesses. Indexing has managed to survive virtually all of them. Why? Because he is possibly the most prepared for the future of all. The market portfolio does not depend on a star manager. It doesn’t care about changes in accounting measures. You’ve seen stocks traded in eighths and decimals. It predates the Internet and will probably survive Web 3.0. As long as companies issue stocks and government debt as their primary means of raising capital and there are enough market participants to express their views on the values ​​of those stocks and bonds in their prices every day, it will be very difficult to approach an investment strategy. ideal within most major asset classes than broad market indexing.

Editor’s Note: A version of this article previously appeared in the April 2022 issue of Morningstar ETFInvestor. Click here to download a free copy.

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