4. Understanding Index-Weighting Choices
The S&P 500 Index was launched in 1957 and has grown to be the best known and most widely followed U.S. stock index in the world. Capitalization (cap) weighting is simple; it weights a company by the number of shares outstanding multiplied by the company’s market price. The effect of cap weighting is that the larger the company, the more effect it has on the index. Because a market cap is partly created by the price of the stock, the market is essentially valuing a company, which affects an index because of the weighting a company is given.
The cap-weighted method is more than 50 years old, and through the years, there have been critics of this method. Criticism includes that the market cap is related to market price, and if a stock has a high price, it might be overvalued. The market-cap method then can over-weight the overvalued companies, because the higher the market price and number of shares out, the more weight a company has in the index. Conversely, the opposite can happen. The lower valued stocks can be too cheap, resulting in less of these cheap stocks going into the index. This can result in the index under-weighting the undervalued companies and over-weighting the overvalued companies.
If a stock is in favor, buyers might drive the stock up to double its starting price. The index, to keep its weighting method, has to increase its holding of that stock. This might not be the best time to buy more of this stock, because if you were trading the stock at some time, you would probably lighten up as the stock climbs. But this is how cap-weighted indexes are constructed. Cap-weighted indexes decree buying more stock as the stock increases in price.
Cap-weighting indexes have rebutted that unless one can say what the true fair market value of a stock is and unless it can be established which companies are overvalued and which are undervalued, the perceived shortcomings of cap-weighted inefficiencies are interesting and may have some validity, but are basically useless.
Is Cap Weighting the Best Way to Weight ETFs?
How indexes should be constructed is a disputed issue for institutional investors, individual investors, and traders. Cap-weighted ETFs might be the most widely held as far as assets under management. But cap-weighted ETFs have come under criticism because it is argued that the method might overvalue the biggest stocks and undervalue the smaller stocks that can lead to larger losses and smaller gains. According to John C. Bogle (founder of the Vanguard Group) and Burton G. Malkiel’s (an economics professor and author of A Random Walk Down Wall Street) article “Turn on a Paradigm?” (The Wall Street Journal, June 27, 2006, Page A14), even though there are new ways to weight indexes, cap-weighting has stood the test of time and is still very valid.
Two economists, among others, think there are better ways to invest than just broad-based, cap-weighted indexes. Eugene Fama, Professor at the University of Chicago, and Kenneth French, Professor at Dartmouth College, suggest there could be higher returns in indexed portfolios of low price-to-book-value ratio stocks. The economists also favor small-cap stocks. Rob Arnott of Research Affiliates (RA) proposes that indexing by weighting stocks by fundamental factors such as sales, earnings, and book values is more effective than cap weighting. Dr. Jeremy Siegel of WisdomTree proposes that an effective way to weight indexes is according to the amount of dividends that companies pay. These index providers and professors propose that fundamentally weighted indexes are the best way to invest.
Mr. Bogle and Mr. Malkiel are of the opinion that cap-weighting indexes has worked well and will continue to be effective. They agree that fundamentally weighted indexes have outperformed cap-weighted indexes during certain years, but this does not mean that cap-weighted indexing is flawed. They point out that cap weighting has done well for its investors for the 30-plus years that they have been available. They have done so well that investors have poured more than $3 trillion into them. Cap-weighted indexes have gotten better returns than investors got before, when they could invest in only actively managed mutual funds.
Also, expenses for alternatively weighted ETFs can be higher than for broad-market, cap-weighted ETFs. Broad cap-weighted ETFs, such as those replicating the S&P 500 Index or the Dow-Jones U.S. Index Fund, usually have expenses of about 10 to 20 basis points. The expenses in fundamentally weighted ETFs are sometimes higher and can be 75 basis points or more.
Mr. Bogle and Mr. Malkiel also point out that fundamentally weighted indexes can incur higher and more frequent transaction costs. In a dividend-weighted index, for example, if one of the companies increases its dividend, then this company has to have a greater weight in the index. The manager has to buy more stock in the company and he has to sell stock in another company. Another occurrence is when a stock increases in price and its fundamentals, such as book value or cash flow per share, remain the same, so a fundamentally weighted index portfolio manager has to sell stock to reduce its weight in the index. This can occur often, causing the ETF to realize a profit.
Mr. Bogle and Mr. Malkiel point out that fundamentally built indexes tend to favor heavier inclusions of value stocks. Fundamental indexing weights according to factors such as high dividends or low book value, and companies have to improve these fundamental factors to have increased weighting in the index. Also, factors such as higher dividends or lower book value are value considerations, thus causing fundamental indexes to have more value stocks compared to cap-weighted indexes.
Cap-weighted proponents often conclude that fundamental portfolios will outperform when small-cap stocks and value stocks are in favor. Ibbotson Associates has compiled numbers that determine there have been long-term excess returns from dividend- paying, value, and small-cap stocks. But these returns can be overstated because fees, taxes, and other expenses were not taken into account. There are times when value portfolios do well, and there are other times when growth portfolios outperform. Value portfolios generally performed better than growth portfolios from the late 1960s through 1977; however, there was little difference between the portfolios in 1977 through 2006.
There is no certainty that any one portfolio construction, be it cap-weighted, dividend-weighted, fundamentally weighted, buyback- and earnings-weighted, or another method, will work in any market, at any time. The index style has to be chosen in the context of the overall market atmosphere.
Are Markets Efficient?
The efficient market hypothesis tries to explain why markets perform the way they do and what markets will do in the future. The hypothesis claims that a stock price reflects all the available information for a company, and therefore, this price is correct and the markets are always correct. Markets are rational, the theory goes, information always changes, and the market price reflects the information as it is released and digested by market participants.
The efficient market model does not solve problems and it raises more questions. If a company, for instance, announces earnings that exceed estimates and its stock rises, should a trader or investor rush in and buy the stock? Or, should a trader short the stock, figuring that the news is out, and the stock’s next move is down? Wherever the stock price goes, it is considered the correct price by those who believe in the efficient market theory. The market price is rational and reflects all information, both widely known and little known information.
If the efficient market hypothesis is correct, then cap weighting is the most efficient and logical way to weight indexes. Cap weighting implies that the markets are right and that stock prices reflect the rational state of a company’s worth. If a stock is selling at 20 times earnings, it is justified, just as if a stock is selling at 50 times earnings. As a stock increases in price, its cap weighting grows, and more of the stock is added to the index.
Many analysts think that the stock market is not rational, and that there is much more that goes into a company’s stock price than the information about that company. This would mean that cap weighting could be flawed, because as a company grows, it has a heavier weight in the index. As a company grows in market cap, because of its stock price, it may be overvalued and heavily weighted in a cap-weight portfolio at just the wrong time.
Maybe the efficient market theory came into existence because people cannot always beat the market, and this theory gives them an excuse if they lose money: Investors or traders can say that they did not know enough. You must know everything, and if anything is missing, you will be wrong.
Which Is Better: Cap Weighting or Alternatively Weighting?
This question is debatable. Some alternatively weighted ETFs have outperformed cap-weighted ETFs some of the time. Some say many alternatively weighted ETFs have been out for only about five years, and that is a short time to measure what will happen in the future and to conclude the superiority of one way to weight over the other.
Investors and traders still have to ask how much risk they want to assume, what size of capitalization exposure they want, in what sector they want exposure, in what region or country, and they also have to decide whether they want inverse exposure or enhanced exposure. They must determine what sort of market they are investing in plus other factors. When considerations like these are resolved, and the investor’s risk and reward profile is clear, the investor can research the various ETFs to find those that fill their needs. How ETFs are weighted is one of the important factors in making investment and trading choices. An investor can clearly favor one way of weighting over another, or might use several index-weighting choices.