Investing Explained: How Does an Index Work?

Benjamin Graham famously wrote in The Intelligent Investor: “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”

Indices that are weighted towards the biggest companies have their benefits. Funds that track market capitalisation-weighted indices cut back on turnover and the related trading costs. They also grasp the market’s collective opinion of each stock’s relative value, a consensus that has historically proven tough to beat. But using a cap-weighted approach with certain markets or strategies is not always the best fit.

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 of the shares.

A company’s share price resulting from this system, when multiplied by the number of shares, forms its market capitalisation. Thus, as a company’s share price appreciates, its market cap and enterprise value grow. The winners of the competitive election process grow bigger and prosper, while the losers are relegated to the boneyard of capitalism. An index weighted by the market cap of its constituents thus accurately reflects the market’s opinion of each firm’s value relative to its peers.

Investors that go against the natural market-cap-weighting process begin to stack the deck against themselves in the form of higher trading costs. This establishes a hurdle that must be overcome by the potential excess returns. It’s incredibly difficult to know whether an approach will generate enough excess return to justify the cost.

What are the Limits of a Cap-Weighted Index?

Market-cap weighting is simple, and the benefits are many. Why would you want to do anything different? It does have some drawbacks that need to be considered.

The assumption that market participants act rationally isn’t necessarily true. History has shown that euphoria can take hold. Just because a market values an asset at a certain price doesn’t mean that value is correct, as numerous bubbles show. 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. This alone is not enough to reject cap-weighting.

In certain markets, the representative index may be constructed from a limited number of constituents, and those with high market caps may become so large that they monopolise the index. In such instances, a market-cap-weighted portfolio may actually be one of the least diversified choices available. This happens with funds that hold a small number of stocks or are exposed to a limited number of regions or countries, such as emerging markets economies such as Peru, South Africa and Qatar, are ripe for this.

One of the primary selling points of these passively managed vehicles is that they provide access to a diversified portfolio of stocks. In the context of international indices, and the funds that track them, diversification should span regions, currencies, and sectors/industries, as well as stocks.

Broad international indices accomplish this goal wonderfully, as do a number of indices that track the broader European market. But applying market-cap weighting to certain regions or countries can compromise the aforementioned objective. Assessing the geographic diversification of the benchmarks that underlie index funds and exchange-traded funds is a crucial element of our assessment of these funds’ processes, which in turn informs our Morningstar Analyst Ratings.

Smaller Companies Are Underweighted

Market-cap weighting carries further implications regarding two of the oldest factors of market returns. Companies with smaller relative market caps, 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.

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 indices? If you’re an investor using low-cost broad-market funds to gain access to US and foreign -market stocks, then a cap-weighted approach is a great option. Just make sure the investable universe is broadly diversified across regions, sectors, and stocks. Alternative approaches may be worth considering if you’re going after a niche market or pursuing a value strategy.