Cap Weighted Indexing?

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timm31
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Cap Weighted Indexing?

Post by timm31 » Thu Dec 15, 2011 3:16 pm

Hello everyone. I have a 401k offering at work with some pretty bad options in it. Trying to find the lesser evil among them. So far i've whittled it down to two options: SPIAX (a cap-weighted S&P 500 index fund) vs VADAX (an equally weighted S&P 500 index fund). Expense ratios are identical. Can you fill me in on what the pro's and con's would be of each choice?

stlutz
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Re: Cap Weighted Indexing?

Post by stlutz » Thu Dec 15, 2011 3:36 pm

The equal-weighted fund ends up being more of a midcap or even midcap value fund since the smallest companies in the 500 get weighted the same as the largest ones. They also end up with different sector weights for the same reason. The cap-weighted fund will trail the index itself by about the same as the expense ratio (~.6%); the EW will trail a tad more because it has more trading costs.

Cap weighted is more of a pure indexing approach and is generally favored here. If it was me, I'd probably do something like 2/3 cap-weighted and 1/3 EW since they will behave differently. But that also depends on on what other investments you might have.

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nisiprius
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Re: Cap Weighted Indexing?

Post by nisiprius » Thu Dec 15, 2011 4:10 pm

The "pro" of equal-weighted indexing is that some people believe it will do better than cap-weighted indexing.

The pros of cap-weighted indexing is that it has unique properties, articulated by Jeremy Siegel in Stocks for the Long Run. Siegel, who is personally associated with a firm that markets non-cap-weighted funds, sets it up in order to knock it down. He immediately follows the passage I'm quoting with an explanation of why the assumptions don't apply perfectly in the real world and therefore justifies a departure from cap-weighting. But this, nevertheless, is the case for cap-weighting:
Capitalization-weighted indexes... under certain assumptions give investors the "best" tradeoff between risk and return. That means that for any given risk level, these capitalization-weighted portfolios give the highest returns, and for any given return, these portfolios give the lowest risk. This property is called mean-variance efficiency.
Also, cap-weighting is the strategy that gives you the maximum distance from from what Bogle calls the "croupiers of Wall Street." When you buy the whole market, cap-weighted, you are effectively on both sides of every trade--measured in dollars--and are therefore are engaging in the least speculation you can possibly engage in. You are tying your personal fortunes to the actual return of the market. That is to say "the market" itself is cap-weighted.

Anything that is not cap-weighting is placing some kind of bet on outpsyching the rest of the market, and assumes that you've found a formula that takes advantage of some kind of persistent mispricing.

I personally don't understand the appeal of an equal-weighted index at all. It seems like a muddled and perverse way to overweight small-cap stocks. If you believe that the small-cap and small-cap-value factors are worth capturing, why not do the math and go straight to the factors? The idea of arbitrarily buying the same amount of everything, just because it is AN "index," just doesn't make any particular sense to me, and I've never heard any convincing rationale for it other than "it did better." One might as well formulate a "Nisiprius index" based on scoring A-Z as 1 through 26 and buying every stock in proportion to the sum of the letters in its ticker symbol.
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Lbill
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Re: Cap Weighted Indexing?

Post by Lbill » Thu Dec 15, 2011 7:43 pm

SPIAX (a cap-weighted S&P 500 index fund) vs VADAX (an equally weighted S&P 500 index fund). Expense ratios are identical. Can you fill me in on what the pro's and con's would be of each choice?
I see these are both Invesco funds, and are load funds with a 5.50% front load. Do you have to pay that? If so, not good. Both are relatively small in terms of net assets.

SPIAX
YTD Return: -2.24%
Net Assets: 368.38M
Front Load: 5.50%
Yield (ttm): 1.09%
Expense Ratio: 0.61%

VADAX
YTD Return: -4.61%
Net Assets: 667.65M
Front Load: 5.50%
Yield (ttm): 1.32%
Expense Ratio: 0.62%

Hard to add to Nisiprius' comments except to mention that typically the turnover for equal-weighted funds is higher than for cap-weighted funds and that can add to higher overhead expenses which can dilute returns somewhat. I happen to favor non cap-weighting and using VADAX may be your only choice for putting more weight on midcaps and small caps and perhaps value. SPIAX is essentially a large-cap growth fund. As Nisi mentions, if you have the choice it might be better to add a small cap or small cap value fund to SPIAX in order to weight small or small value, but it sounds like you might not be able to do that
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Re: Cap Weighted Indexing?

Post by pkcrafter » Thu Dec 15, 2011 8:24 pm

An equal-weighted index by definition cannot be a true index because true cap-weighted indexes track where investors are actually putting their money. The equal-weighted index holds 47% in mid caps whereas the S&P500 holds a market mirror 13%. So equal weighting is making a big bet against investor consensus. There may be higher returns in mid caps, but they come with equally higher risk. Robert Arnott, when he wanted to create a different index, looked closely at equal-weighting, but after doing the research he concluded it would not outperform standard cap-weighting after turnover and increased operating costs.

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Re: Cap Weighted Indexing?

Post by peter71 » Fri Dec 16, 2011 12:32 am

Equal-weighting is actually pretty strategy-free too (particularly as opposed to trying to mirror "factors" derived from some B-School profs' equations. One means you put 5% of your money in Apple because Apple is 5% of the market (and almost nothing on the 500th largest company); another means you put 0.2% of your money on each of the 500 biggest companies. It's been argued here before and will be argued here again, but truth be told it probably won't much matter either way.

Best,
Pete

P.S. An EW index is perfectly consistent with the academic def of "index," and this too has been argued before.

P.P.S. I hate to even bring up past performance, but Arnott was of course off by a mile (and needed to sell something others weren't already selling). Since inception in 1999 the RSP equal-weighted SP500 fund has outperformed VFINX 84% to 16% despite much higher expenses . . . again, I wouldn't even bring this up were it not for the comments above.

http://stockcharts.com/freecharts/perf. ... 2C%20VFINX

DickBenson
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Re: Cap Weighted Indexing?

Post by DickBenson » Fri Dec 16, 2011 2:38 am

pkcrafter wrote: Robert Arnott, when he wanted to create a different index, looked closely at equal-weighting, but after doing the research he concluded it would not outperform standard cap-weighting after turnover and increased operating costs.
Did Arnott or anyone else compare the performance of the equal-weighted and cap-weighted S&P 500 if turnover and other operating costs were not considered?

Dick

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Re: Cap Weighted Indexing?

Post by YDNAL » Fri Dec 16, 2011 9:31 am

pkcrafter wrote:An equal-weighted index by definition cannot be a true index because true cap-weighted indexes track where investors are actually putting their money.
Yes and No.
  • - Yes, investors in cap-weighted Indices put a lot of their money in the larger companies because - by construction - the Index forces their money there. Peter puts it nicely...
    peter71 wrote:One means you put 5% of your money in Apple because Apple is 5% of the market (and almost nothing on the 500th largest company); another means you put 0.2% of your money on each of the 500 biggest companies.

    - No, investors put their money ALSO in Small Cap Value, Mid Caps, REIT (mostly Small and Mid), etc. etc. - actually creating their individual "non-cap weighted" Total Market Index.
As you know, in a cap-weighted S&P 500, the Top 10 companies (including three behemoths: Apple, Exxon, IBM) take $0.20 of every $1. The other 490 companies take $0.80. Imagine, the #500 of the larger companies in the US gets almost nothing of your money!!!
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heyyou
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Re: Cap Weighted Indexing?

Post by heyyou » Fri Dec 16, 2011 9:45 am

Consider buying some of each fund to avoid tracking error regret. Rebalance between them, but not often.

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kenyan
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Re: Cap Weighted Indexing?

Post by kenyan » Fri Dec 16, 2011 3:22 pm

peter71 wrote:
P.P.S. I hate to even bring up past performance, but Arnott was of course off by a mile (and needed to sell something others weren't already selling). Since inception in 1999 the RSP equal-weighted SP500 fund has outperformed VFINX 84% to 16% despite much higher expenses . . . again, I wouldn't even bring this up were it not for the comments above.

http://stockcharts.com/freecharts/perf. ... 2C%20VFINX
Of course it did. It's half mid-cap. Mid-caps did far better than large caps over that period.
Retirement investing is a marathon.

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Re: Cap Weighted Indexing?

Post by peter71 » Fri Dec 16, 2011 5:25 pm

Kenyan: I could just as easily say, "of course mid-caps outperformed large caps . . . "large caps" is just a made up category based on arbitrary cutoff points that refers to the largest companies in the S&P 500, and "mid caps" is just an arbitrary category that tends to refer to the remainder." The CRSP "deciles 1-10" approach is a well-known example of thinking of the market in terms of proportions rather than absolute market-cap cutoffs. The point is there's nothing inherently more real about a "mid cap" premium than a "CRSP 4-6" premium or an "ordinal rank 101-500 premium" . . . it's just that one has been popularized more than the others.

Landy: I'm not sure we're disagreeing. I'm saying that a cap-weighted 500 fund puts 5% in Apple, whereas an equal-weighted 500 fund puts 0.2% on each of the 500 companies. I lean towards a preference for equal-weighting, but in practice I don't think it matters because: a) I think prices for all of the top 500 stocks are reasonably efficient and b) even a 5% bet on Apple isn't that concentrated a bet.

Best,
Pete

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Re: Cap Weighted Indexing?

Post by YDNAL » Sat Dec 17, 2011 6:52 am

kenyan wrote:
peter71 wrote:P.P.S. I hate to even bring up past performance, but Arnott was of course off by a mile (and needed to sell something others weren't already selling). Since inception in 1999 the RSP equal-weighted SP500 fund has outperformed VFINX 84% to 16% despite much higher expenses . . . again, I wouldn't even bring this up were it not for the comments above.
Of course it did. It's half mid-cap. Mid-caps did far better than large caps over that period.
The S&P 500 selection (by committee) is what it is.
  • The largest company in the Index has a Market Capitalization of $390 billion and the smallest company of only $830 million (last I looked).
  • Actually, the largest company in the S&P 400 Mid Cap Index has a Market Capitalization of $10.1 billion or 12 times larger than the smallest company in the S&P 500.
    http://www.standardandpoors.com/indices ... --p-us-m--
All that said, when you invest in the S&P 500 - like typically in most 401K plan's best choice - that $830 million company is getting almost nothing of your money. As an investor, one should determine if this is what you want.
peter71 wrote:Landy: I'm not sure we're disagreeing.
We are not.
Landy | Be yourself, everyone else is already taken -- Oscar Wilde

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kenyan
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Re: Cap Weighted Indexing?

Post by kenyan » Sun Dec 18, 2011 3:23 am

I'm not sure I understand your point. I'm not talking about anything theoretical - you stated that a portfolio that's basically 50% large-cap and 50% mid-cap did better than an 80% large-cap and 20% mid-cap. Mid-caps, in general, did significantly better than large-caps over that time period (1999-present = whether or not you want to classify them in these large, generic buckets). It doesn't matter how you classify the deciles or what the factor loadings or premiums are; it's just how those segments of the market did during that period. How they'll do in the future is a different matter.

Ah well, perhaps you're trying to say something I'm not grasping.
Retirement investing is a marathon.

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