Why are indexes Market Cap Based?

[theonewhowaskazu]

Not gonna lie, this article influences this content.

First, let me say that I don't think indexes are socialism so long as people invest in them by their own free will. This is similarly false:

Indexation could work if it remained a satellite strategy, with say 10% of the money being managed through indexation, the rest being managed by active money managers. As such, it would be a parasitic strategy. Indexers would benefit from the price discovery work done by others without paying the costs associated with the process.

Since a money manager improves price discovery when alpha is obtained (i.e, buy low sell high means that you push the price up through buying when the price is low, and push the price down by selling when the price is high), the only investors that are helping with  price discovery are those that outperform the index, an outperformance which, of course, they are getting rewarded for, while those investing directly in the index are not.

But, the article does bring up an interesting point. Namely,

Active money management is essentially a ‘mean reversion’ strategy. That’s not so for indexation. In the indexation process, there is no attempt at price discovery. The only thing that matters is the relative size of the asset: the bigger the market capitalization, the more an investor should own. This means if the price of a large asset goes up more than the market as a whole, indexers have to buy even more of it.

When you're saying it that way, you realize that it really is quite weird, and opens the door for all kinds of market manipulation.

That seems like an incredibly odd system. Why not index by earnings, instead of by market cap? That way your index actually buys a larger % of companies with a low PE, than companies with a high PE, among companies with the same EPS?

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[odolvlobo]

The article is flawed.

Thus indexation is a momentum-based strategy.

That is false. A fund does not need to buy or sell a company's stock if the market cap changes. The allocation is the same no matter what happens to the market cap. The author should have checked his math.

Here is an example:
Suppose an index fund contains two stocks, both with market caps of $100, and the fund owns $1 worth of shares of each stock. Suppose the stock price of company A doubles. Now the fund owns $2 of A and $1 of B without doing anything. The fund's weighting is still correct because A has a market cap of $200 and B has a market cap of $100.

the bigger the market capitalization, the more an investor should own. This means if the price of a large asset goes up more than the market as a whole, indexers have to buy even more of it.

A market cap weighted fund owns the same percentage of every company in the index. For example, if the market cap of an S&P 500 index fund is 1% of the total market cap of the companies in the index, then the fund owns 1% of each of the companies in the index. So, in that sense, the fund does not own more of a big company than a small company.

[theonewhowaskazu]

The article is flawed.

the bigger the market capitalization, the more an investor should own. This means if the price of a large asset goes up more than the market as a whole, indexers have to buy even more of it.

A market cap weighted fund owns the same percentage of every company in the index. For example, if the market cap of an S&P 500 index fund is 1% of the total market cap of the companies in the index, then the fund owns 1% of each of the companies in the index. So, in that sense, the fund does not own more of a big company than a small company.

The problem is not with "big" companies and "small" companies, its the fact that "bigness" is measured through the market cap, rather than actual earnings. Actually to be honest, I'm not sure what the article was saying exactly, but that's what I'm getting at. It owns a larger $$$ amnt of companies with a high PE, than of companies with a low PE, for companies with the same total earnings. Doesn't that seem a bit weird to you? It means that $ volume of a stock should always go up as the price (in terms of PE) goes up. Thats basically letting supply play a huge roll in setting the price, rather than people actually making rational decisions. Doesn't that seem a bit problematic?

Thus indexation is a momentum-based strategy.

That is false. A fund does not need to buy or sell a company's stock if the market cap changes. If the market cap changes, the allocation automatically changes by the appropriate amount. The author should have checked his math.

I'm not quite sure what you're getting at here.

[Possum577]

Indexing by earnings is a cool idea. It would add a new dimension to investing. But it may also influence business decisions by the company, perhaps they wouldn't be as willing to take a risk on a new venture if it posed the potential consequence of significantly reduced earnings and a resulting de-listing from the index.

It's probably best to have the dimensions of indexing be based on criteria that's agnostic of the company's daily decisions (i.e., geography, sector, market cap).

[anivia]

Earn with investing, invest with your earnings, thats a cycle actually for your growth.. We read out market trends, analyze how indexes are behaving & then we invest, ofcourse index runs when there is growth or decline because its variables are dependent of market fluctuations. 

[odolvlobo]

One benefit of a market cap weighted index is that the fund doesn't have to trade much. A PE-weighted index fund would have to trade constantly.

The problem is not with "big" companies and "small" companies, its the fact that "bigness" is measured through the market cap, rather than actual earnings. Actually to be honest, I'm not sure what the article was saying exactly, but that's what I'm getting at. It owns a larger $$$ amnt of companies with a high PE, than of companies with a low PE, for companies with the same total earnings. Doesn't that seem a bit weird to you?

It doesn't seem weird to me. The purpose of a market cap weighted index is to represent the entire market. If the amount of money invested in a company is more, then the company is a bigger portion of the index.

It means that $ volume of a stock should always go up as the price (in terms of PE) goes up. Thats basically letting supply play a huge roll in setting the price, rather than people actually making rational decisions. Doesn't that seem a bit problematic?

I didn't understand what you wrote there, but market cap index funds don't affect prices (in theory) because they don't have to trade to match the index.

[crazyALT47]

the Dow jones industrial average is based on the price of the 30 stocks the the market cap of the stocks.

[theonewhowaskazu]

One benefit of a market cap weighted index is that the fund doesn't have to trade much. A PE-weighted index fund would have to trade constantly.

Yeah, that is a point. Probably some tax problems there. I wasn't considering that dimension. However, you could always rebalance quarterly. Lots of funds do that already.

The problem is not with "big" companies and "small" companies, its the fact that "bigness" is measured through the market cap, rather than actual earnings. Actually to be honest, I'm not sure what the article was saying exactly, but that's what I'm getting at. It owns a larger $$$ amnt of companies with a high PE, than of companies with a low PE, for companies with the same total earnings. Doesn't that seem a bit weird to you?

It doesn't seem weird to me. The purpose of a market cap weighted index is to represent the entire market. If the amount of money invested in a company is more, then the company is a bigger portion of the index.

Except the market cap of a company isn't representative of the amount of money invested into a company, its merely a pricing for that company. Assume there's a company that collects $1B through an ipo. It takes that $1B and sticks it into a bank account somewhere, doesn't  do anything else with it. Now theoretically that stock can be bid up above the IPO price. Say, making the market cap $2B. The $1B is what is really representative of the company's worth, what was 'invested' into it. If you wanted to do this, you should weight your index based on the net book value of a company, not its market cap.

It means that $ volume of a stock should always go up as the price (in terms of PE) goes up. Thats basically letting supply play a huge roll in setting the price, rather than people actually making rational decisions. Doesn't that seem a bit problematic?

I didn't understand what you wrote there, but market cap index funds don't affect prices (in theory) because they don't have to trade to match the index.

This is only assuming the inflow/outflow of the ETF is 0 at all times.

[Mobius]

Market cap based Indexes make the most sense. If you were to have an index that measures it's price any other way then it would not be able to truly measure the performance of the companies in the index.

If the index used share price (like the DJIA does) then companies that have a high per share price would have a greater effect on the index then a company that has a low per share price, even if both companies are otherwise exactly the same.

Another option would be to have all companies be equally weighed, however this would make it unfeasible to effectively be able to invest in the index as small companies in the index would not have enough shares available.   

[theonewhowaskazu]

Market cap based Indexes make the most sense. If you were to have an index that measures it's price any other way then it would not be able to truly measure the performance of the companies in the index.

If the index used share price (like the DJIA does) then companies that have a high per share price would have a greater effect on the index then a company that has a low per share price, even if both companies are otherwise exactly the same.

Another option would be to have all companies be equally weighed, however this would make it unfeasible to effectively be able to invest in the index as small companies in the index would not have enough shares available.   

Why not earnings as I said before, or even PEG ratio?

[Mobius]

Market cap based Indexes make the most sense. If you were to have an index that measures it's price any other way then it would not be able to truly measure the performance of the companies in the index.

If the index used share price (like the DJIA does) then companies that have a high per share price would have a greater effect on the index then a company that has a low per share price, even if both companies are otherwise exactly the same.

Another option would be to have all companies be equally weighed, however this would make it unfeasible to effectively be able to invest in the index as small companies in the index would not have enough shares available.   

Why not earnings as I said before, or even PEG ratio?

PEG would generally favor smaller companies as small companies have a much easier time growing their earning then larger companies do. By giving small companies a larger weight, the index would not really be properly measuring the industry(ies)/economy that it is trying to measure.

Earnings would not work because every industry has it's ups and downs, and companies in an industry that is not doing well will have lower earnings, or possibility even temporary negative earnings (losses) and it would likely not be appropriate to exclude a company from an index just because it has losses (if it's earnings were negative then it would have no way of being included in an Index that weighs in earnings). Another issue is that a lot of companies have a lot of "one time" expenses that lower earnings for only one or two quarters but will not last forever.