Pros and cons of market capitalization weighted indexing

How would you describe the ideal investment strategy? And no, “buy low, sell high” doesn’t matter. Personally, I would describe the ideal investment strategy as having these six traits:

1) Miscellaneous

2) inexpensive

3) Tax efficiency

4) Tons of capacity

5) It performs well in the long run

6) Can be used well by investors

I would argue that market value-weighted indexing ticks all these boxes. But while there’s a lot to be said for letting Mr. Market do most of the heavy lifting for you, there’s no guarantee there won’t be moments when you guess the wisdom of the market and your decision to strap your cart to its carts. every whim. Like any sound investment strategy, indexing will not look perfect at every turn in the market cycle. The best attributes of indexing are not necessarily universal, especially since indexing has shifted from broad market measurement to compiling lists of stocks that may or may not have anything to do with the subject du jour – from AI to Generation Z. Here, I’ll look at the pros and cons of value-weighted index funds. market in more detail.

free lunch

Economist Harry Markowitz is credited with formulating the concept that diversification is the only free lunch in finance. If diversification is a free lunch, low-cost total market index funds are a lunch buffet you can eat. These funds hold as many securities as possible in their investment range and weigh them according to their current value. As an investor, you can’t roll out a wider network, and you can’t do any less work. Indexers are self-employed. They can’t be bothered lifting a finger in an attempt to figure out the value of something. They leave it to the market.

But not all indexes are broad. The tighter the index, the less likely investors are to enjoy the full benefits of budge along with the benchmark. This is especially evident in less liquid markets, such as high-yield bonds and bank loans. Since index funds in these corners of the market must place a premium on investment and liquidity, they often lose out on some of the richest veins in the pool of investment opportunities. These are areas where investors are often better served by smart, active managers.

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

least is more

Market value-weighted index funds usually don’t charge much – if anything at all. From the point of view of investors, this is ideal. After all, in the words of the late Jack Bogle, “In investing, you get what you don’t pay for.” The Vanguard Total Stock Market ETF VTI is the class of publicly traded stocks in the world’s largest mutual fund, with more than $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 through March 2022 lagged its split index by only 0.01% annually. This was thanks to a combination of smart portfolio management and stock lending income. As close as you can get to just about anything, Vanguard has provided returns in the US stock market for investors for decades.

But why pay anything? In August 2018, Fidelity launched a group of zero-fee index mutual funds, among them Fidelity Zero Total Market Index FZROX. As the name of the fund suggests, it does not charge any fees, and it does not have a minimum investment requirement.

The proliferation of low-cost index funds has been a boon for investors. But as fees approach or reach zero, their impact on the long-term returns of these funds has diminished. For example, from the start of the 2018 Fidelity Zero Total Market Index to March 31, 2022, it has outperformed the VTI Index by 0.10% year over year. Only a small part of this outperformance can be explained by the differences in the fees of the two funds. As expense ratios shrink, subtle differences in index methodologies, portfolio management practices, and stock lending programs will have a much greater impact on the returns of seemingly identical index funds over the long term.

tax season

Market value-weighted indices tend to have low turnover. All else being equal, lower turnover means lower taxes in the form of taxable capital gains dividends. Broad market index funds have generally been more tax efficient than their active counterparts. But this is not always the case and is only partially due to their relatively low turnover. There are a lot of index mutual funds that have paid large tax bills to their investors over the years.

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

no limits

Broad market benchmarks don’t hit capacity constraints the way an energetic manager working in the small business value space might. Sweeping the full spectrum of securities in their investing world and being price-aware means that broad market index funds won’t suffer from asset inflation as a little clever stock picker might be. As such, investors need not worry that adding the next dollar to their stock market index fund total will harm the portfolio managers’ ability to perform. Mr Market is happy to take that dollar, the next dollar, and the next dollar.

But what about the impact of the torrential flows into index funds? Should investors be alarmed by the programmed buying by hordes of retired savers? The only honest answer I can give to this question is: I don’t know. But I know people have been mudding through the catalog since day one, calling it “un-American,” “worse than Marxist,” blaming it for stifling initial public offerings, and more. And all these mockery and “tail-tail” arguments are not new. Long before index funds became a “tail”, market professionals were concerned about the “situation of mutual funds.”

I’m not convinced that indexing growth has been detrimental to markets or investors. If anything, it is likely that any deterioration in the efficiency of markets was more than offset by the countless billions of investors who saved in fees, transaction costs and taxes. If the day comes when the next dollar earmarked for an index fund causes the markets to go inside, I’m sure there will be enough incentives for market participants to step in and fix things up. I believe in the self-healing power of markets โ€” because their poor health offers profit opportunities.

only average

By definition, broad market index funds are average. In any given year, about half of active funds will perform better, and about half will do worse. But over longer periods, being just average can lead to better-than-average results – sometimes much better. why is that? First, because index funds’ fee advantage accrues over time. Second, because most active chests don’t work.

The data supports this. The Morningstar Year-End 2021 Active/Passive measure showed that over the decade to December 31, 2021, only 26% of actively managed funds available at the start of that 10-year period were able to survive and outperform their indexed peer average. Over longer time horizons, the advantage of index funds is exacerbated further. Sometimes being totally average is totally okay.

Relative predictability

The ideal investment strategy is one that you can stick to. But hanging is hard, well, hard. I would argue that it is easier to sit tight if you know exactly what you are signing 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’d expect. If investor expectations are appropriately calibrated from day one, I think they are more likely to stick with their strategy through thick and thin. It’s hard to imagine a strategy with clearer expectations than indexing.

Don’t meet your idols

There is no perfect investment strategy – not even a broad weighted indicator of market value. Every strategy out there – from the Nifty Fifty to everything the Renaissance Medal Fund does – has strengths and weaknesses. Indexing has managed to withstand almost all of them. why? Because he is arguably the most futuristic of them all. Market Portfolio does not depend on the Star Manager. It is not concerned with changes in accounting measures. I have seen stocks quoted in decimal places and prices. It predates the Internet and is likely to continue after Web 3.0. As long as companies are issuing public equity and debt as a primary means of raising capital and there are enough market participants pumping their opinions on the values โ€‹โ€‹of those stocks and bonds into their prices every day, it will be very hard to get close to that. An ideal investment strategy within most major asset classes of 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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