Back in 1976 John Bogle reinvented the fund management industry by setting up Vanguard and selling low-cost index tracker funds to individual investors. Those funds weight their individual stock holdings based on market capitalisation. That makes them cheap to run, easy to manage and guarantees that they won’t get left behind by the index. But the downside of course is that they offer zero prospect of ever outperforming. This has led to deeper research into how stock portfolios can be better weighted to capture the market premium. For investors considering how to structure their own stock portfolios, it’s an essential subject to explore.
The problem with market cap weighting
Weighting an index according to market-cap is nothing new; after all, it’s how the FTSE 100 and S&P 500 are constructed. For many funds, particularly trackers that use these indexes as benchmarks, it makes sense to do the same. Quite simply, if Apple represents 3.5% of the total value of the S&P 500 (as it did over the summer) then Vanguard’s S&P 500 ETF will have around 3.5% exposure to the stock. The same goes for every other stock in the index.
But for an investor that wants to beat the index, this is a daft approach. By definition, a market-cap-weighted index has a larger weighting in shares that increase in value and a smaller weighting in shares whose prices decrease. The problem with that - as Joel Greenblatt explains in The Big Secret for the Small Investor - is that when Mr Market gets over-excited about certain companies and overpays, their weighting in the index rises. So the index fund ends up being more heavily weighted in overpriced stocks. And when Mr Market is pessimistic about certain companies, the opposite happens. They can fall below fair value and the index ends up owning less of these potentially bargain-priced stocks.
As Greenblatt explains: “In effect, if emotions really do drive certain stocks to be overpriced and others to be underpriced, a market cap weighting guarantees that we will own an inferior portfolio.”
The equal weighted advantage
For this reason, equally weighted indexes, funds and portfolios have grown in popularity as a way of shedding some of the bias towards buying mispriced stocks. Earlier this year, the Quantitative Equity Research team at Societe Generale took a close look at this. Having launched an equally-weighted ‘global value index’, they wanted to see how different methods of weighting a portfolio…
