Is market capitalization the correct metric?

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Gaston
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Is market capitalization the correct metric?

Post by Gaston »

When it comes to the indices that track large segments or all segments of a market (S&P 500, total stock market, etc), my understanding is that those indices weight companies on market cap. Is there any research, however, demonstrating that, from an investor point of view, market cap is the best weighting approach?

There is an infinite number of ways that an index could weight its component stocks, such as by net sales, by price-to-book ratio, by the number of vowels in each company's name, etc. So how do we know that market cap provides the best basis for investor decisions?

And yes, I am aware that if one wants to segment the market, one can find indices that tilt toward growth v value, large cap v small cap, or technology v consumer discretionary, among many others. But to be clear, that's not what I'm talking about here. I'm not asking about segmenting the market; I'm wondering whether the use of market cap, as the weighting methodology in total market indices, best serves the investor.

If anyone knows of reliable research on this topic, I would appreciate if you could post a source or a link. Thx.
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Re: Is market capitalization the correct metric?

Post by jeffyscott »

Are you aware of the RAFI indexes, that do weight based on sales, cash flow, dividends, book value?

https://www.researchaffiliates.com/en_u ... index.html

You can find their research regarding this in the "Insights" section there.
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Ben Mathew
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Re: Is market capitalization the correct metric?

Post by Ben Mathew »

The market cap metric is the correct metric if the goal is the market portfolio. Everything else is a tilt--you would be holding less of one company and more of another (relative to other investors). If markets are efficient, that can't be the right thing for everyone.

In other words, if you accept the efficiency of a market portfolio, then weighting by market cap is the right way to go. If you don't, that opens the door to other weights. Weighting by fundamental metrics is an example. But these are tilts.
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Re: Is market capitalization the correct metric?

Post by nisiprius »

I don't know the theory in depth, this is stuff I've "read about," not "understand..." but with suitable assumptions the answer is "yes." According to authorities I trust.

If the assumptions behind the theory are incorrect, then the theory won't be correct. And if you personally have good reasons for wanting to maximize something different from what the theory says cap-weighting maximizes, then you will want something different.

But it is not the case that cap-weighting is just some arbitrary choice, not just a matter of opinion. The Leaning Tower may have good properties, but it is the tower that leans, not the plumb line. Cap-weighting is the plumb line.

For starters, remember that the market itself is cap-weighted. The number of dollars in a stock is the number of dollars in that stock. The collection of all of the assets in a market, "the market itself," is called "the market portfolio." A cap-weighted total market index fund mirrors the market portfolio. Nothing else does, everything else is a departure from it.

What the theory says is that under a set of pretty strong assumptions, it can be shown mathematically that market cap weighting has the highest risk-adjusted return. I'm going to quote the current edition of Jeremy Siegel's Stocks for the Long Run. This is particularly significant because Siegel himself developed a different weighting system, a form of "fundamental indexing," that is used by a fund company he advises. So he actually recommends something different from cap-weighting, but is willing to state the part of the theory that he things is valid.
...capitalization-weighted indexes have some very good properties. First, as noted earlier in the chapter, these indexes represent the average dollar-weighted performance of all investors, so that for anyone who does better than the index, someone else must be doing worse. Furthermore, these portfolios, under the assumption of an efficient market, give investors the "best" tradeoff between risk and return. This 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.
Cap-weighted indexing was originally developed by the economist Irving Fisher, in a 1922 book entitled The Making of Index Numbers, and I don't know his exact rationale--it wasn't mean-variance efficiency--but it was widely accepted, used by the Cowles Commission in their monumental 1938 book that is the basis of most stock data you see "going back to 1871, and adopted by S&P in 1957 for the structure of the S&P 500 index.

Be aware that there are obvious self-interested motives for "everybody" to attack cap-weighing. There isn't a lot of money to be made in cap-weighted total market index funds, and very hard for anyone compete against the established giants like Vanguard (iShares, Fidelity...) So it is understandable that there is a lot of gotta-have-a-gimmick, "my-weighting-is-better-than-cap-weighting" rhetoric.

Going back to Siegel and the firm he advises, here's the comparative performance of the oldest and second-largest WisdomTree ETFs, DLN; this is their large-cap fund that uses fundamental indexing (blue) compared to the S&P 500, which is cap-weighted (orange). It may be argued that the comparison is unfair because DLN is value tilted and the value factor has underperformed for a long time, but in this case I think it is reasonable because the fund is not targeted directly to the value factor. It is, rather, fundamentally indexed and the value tilt emerges from the decision to weight on fundamentals.

Source

Image
Last edited by nisiprius on Sat Jun 12, 2021 10:16 am, edited 2 times in total.
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JoMoney
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Re: Is market capitalization the correct metric?

Post by JoMoney »

Gaston wrote: Sat Jun 12, 2021 8:33 am... Is there any research, however, demonstrating that, from an investor point of view, market cap is the best weighting approach?...
"best" at what? By what measure or goal is this hypothetical investor supposed to be using to benchmark whether the portfolio is better/worse at achieving that objective?
Regardless of what that objective is, if everyone had that same objective, market cap weighting would allow for all the invested money to be divided across those assets in such a way that you couldn't create another portfolio that was any better (by that same metric) without making another portfolio worse.
In the real world, not all individuals have the same values/preferences, some might prefer different levels of risk, some might have strong feelings towards specific brands/companies/CEOs, different age groups might be in different stages of accumulation and withdrawal, some people will be under different tax laws, different areas might have laws favoring or disallowing certain investments. Specific individuals might have reasons there portfolio won't look like the average of everybody's money added together (which is what market cap weighting does)... but on the other hand, when it comes to saving money and trying to make it grow people aren't hugely different, and market cap weighting is what the "average" is, and unless you think there's some sucker willing to hold the lesser portfolio that you can take advantage of, it's probably a pretty good way to go.
In aggregate the market as a whole isn't going to achieve anything more by people holding it at different weightings.
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Re: Is market capitalization the correct metric?

Post by David Jay »

JoMoney wrote: Sat Jun 12, 2021 9:36 am...and unless you think there's some sucker willing to hold the lesser portfolio that you can take advantage of, it's probably a pretty good way to go.
Interesting, I had never looked at it that specific way. If one's "not-market-portfolio" overperforms it is because someone else's not-market-portfolio underperforms.
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Re: Is market capitalization the correct metric?

Post by BogleFan510 »

An example of other weights is offered by Charles Schwab's Fundamental Weighted Index funds. If you use their robo service they allocate some percentages to these funds. Since the fees are higher (not horrible, but higher), I dont use them. I also dont use the robo since it forces a cash allocation. If they ever allow user selected fund allocations I might consider their robo offering, but ...profits, etc.
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Re: Is market capitalization the correct metric?

Post by Ben Mathew »

David Jay wrote: Sat Jun 12, 2021 10:17 am
JoMoney wrote: Sat Jun 12, 2021 9:36 am...and unless you think there's some sucker willing to hold the lesser portfolio that you can take advantage of, it's probably a pretty good way to go.
Interesting, I had never looked at it that specific way. If one's "not-market-portfolio" overperforms it is because someone else's not-market-portfolio underperforms.
This is related to the arithmetic of active management.

The sum of all non-market portfolios equals the market portfolio.
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David Jay
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Re: Is market capitalization the correct metric?

Post by David Jay »

Ben Mathew wrote: Sat Jun 12, 2021 11:17 am
David Jay wrote: Sat Jun 12, 2021 10:17 am
JoMoney wrote: Sat Jun 12, 2021 9:36 am...and unless you think there's some sucker willing to hold the lesser portfolio that you can take advantage of, it's probably a pretty good way to go.
Interesting, I had never looked at it that specific way. If one's "not-market-portfolio" overperforms it is because someone else's not-market-portfolio underperforms.
This is related to the arithmetic of active management.
Yup, it was just the different perspective that caught my eye.

The market portfolio is actually a gracious choice, because one is not trying to make a "sucker" out of another investor in a zero-sum game.
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Re: Is market capitalization the correct metric?

Post by vineviz »

Gaston wrote: Sat Jun 12, 2021 8:33 am There is an infinite number of ways that an index could weight its component stocks, such as by net sales, by price-to-book ratio, by the number of vowels in each company's name, etc. So how do we know that market cap provides the best basis for investor decisions?
As others have pointed out you must first specify the goal before you can ascertain the "best" way to achieve it.

Market cap weighting strategies are exceptionally good at minimizing portfolio turnover, minimizing tax impacts, and lowering management costs.

Market cap weighting strategies are NOT particularly good at maximizing diversification, maximizing expected return, or minimizing portfolio volatility.

Those are just six possible criteria you could use to evaluate which approach is "best" there are many others, and likely no two people will completely agree on how much emphasis to put on each one.
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Re: Is market capitalization the correct metric?

Post by vineviz »

nisiprius wrote: Sat Jun 12, 2021 9:25 am But it is not the case that cap-weighting is just some arbitrary choice, not just a matter of opinion. The Leaning Tower may have good properties, but it is the tower that leans, not the plumb line. Cap-weighting is the plumb line.
The market cap weighted portfolio is indeed an "arbitrary choice" in the sense that there is nothing intrinsic to that weighting scheme which makes it superior to any other.

If you asked me whether a Honda Odyssey produces more horsepower or less horsepower than a Bugatti Chiron, there is only one right answer to that question. The criteria is specified in the question, so I have no discretion about which answer to choose (assuming I'm trying to answer correctly).

If you asked me whether a Honda Odyssey is a better vehicle than a Bugatti Chiron, there are multiple "right" answers to that question. "Better" depends on both the intended use and the respondent's personal preferences. For instance, I might say the Odyssey is a better vehicle for a family with three children who must carpool to school every day. Or I might say the Bugatti is a better vehicle for a single driver who will do circuits at Sebring every weekend.

Implicit in your Leaning Tower example is an assumption that "tilt relative to the direction of gravity" is the right metric: that's what allows you to conclude it's the tower which leans. But what if we prefer to measure tilt relative to the Leaning Tower of Pisa"? Now every other building in the world leans. Sure it's an absurd example, but it illustrates the importance of examining the assumptions we use.

The market cap weighted portfolio has many "special" qualities: it's the only single portfolio everyone can hold, it's the only portfolio that never requires rebalancing (sort of), it's the portfolio with minimizes transaction costs, etc.

But not everyone will agree that THOSE special qualities are the most important ones, which is what makes market cap weighted portfolio just one choice of many.
Last edited by vineviz on Sat Jun 12, 2021 12:36 pm, edited 1 time in total.
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Re: Is market capitalization the correct metric?

Post by nisiprius »

You hear relatively little these days about "fundamental indexing." That's because, in my cynical opinion, the products that described themselves that way have now been out long enough to demonstrate lack of any clear superiority. I already showed Wisdomtree's DLN above, but since Schwab was mentioned, let's look at theirs too, and Fidelity's. I'll use PortfolioVisualizer this time so we can see standard deviation, drawdown, and Sharpe ratios.

Source

Image

Evaluate these on the basis of what criteria are important to you. I will say this: the cap-weighted Vanguard S&P 500 (green) was not bad.
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Re: Is market capitalization the correct metric?

Post by David Jay »

vineviz wrote: Sat Jun 12, 2021 12:11 pm
nisiprius wrote: Sat Jun 12, 2021 9:25 am But it is not the case that cap-weighting is just some arbitrary choice, not just a matter of opinion. The Leaning Tower may have good properties, but it is the tower that leans, not the plumb line. Cap-weighting is the plumb line.
The market cap weighted portfolio is indeed an "arbitrary choice" in the sense that there is nothing intrinsic to that weighting scheme which makes it superior to any other.
It is not that it is superior, it is the plumb line because the market is what is out there. It is reality, there is nothing "arbitrary" about reality. The market is what the market is. Superior. Inferior. Good. Bad.
vineviz wrote: Sat Jun 12, 2021 12:11 pm But what if we prefer to measure tilt relative to the Leaning Tower of Pisa"? Now very every other building in the world leans. Sure it's an absurd example, but it illustrates the importance of examining the assumptions we use.
Again, we use reality. What is out there. Gravity always generates a force towards the center of the mass, so the plumb line always works. Selecting a different measurement is arbitrary and would be hugely problematic.
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Re: Is market capitalization the correct metric?

Post by JoMoney »

David Jay wrote: Sat Jun 12, 2021 11:18 am
Ben Mathew wrote: Sat Jun 12, 2021 11:17 am
David Jay wrote: Sat Jun 12, 2021 10:17 am
JoMoney wrote: Sat Jun 12, 2021 9:36 am...and unless you think there's some sucker willing to hold the lesser portfolio that you can take advantage of, it's probably a pretty good way to go.
Interesting, I had never looked at it that specific way. If one's "not-market-portfolio" overperforms it is because someone else's not-market-portfolio underperforms.
This is related to the arithmetic of active management.
Yup, it was just the different perspective that caught my eye.

The market portfolio is actually a gracious choice, because one is not trying to make a "sucker" out of another investor in a zero-sum game.
I always liked "The Gotrocks Family" parable written by Warren Buffett and included in John Bogle's "Little Book of Common Sense Investing"
http://johncbogle.com/wordpress/wp-cont ... %20one.pdf

and
The Inefficient Market Argument for Passive Investing - Thorley, Steven (1999)
The Old link to the paper ( marriottschool.net/emp/SRT/passive.html ) doesn't work anymore, but I'm sure the paper is still floating around

But there is still the idea that everyone doesn't have the same objective(s), they don't have the same risk profiles, or tax situations. There is room for people to have different portfolios, and for each to be better off than if they were holding the opposite or some amalgamation of the broad average... but it's worth thinking about why and how many would be holding the opposite side of whatever portfolio... and most people probably don't have a good reason to stray far from the broad average. If the market is "efficient" it's all just about finding the balance of risk/return, if it's not "efficient" then there are suckers to be taken advantage of, and one should be careful that if they're not a professional in that game they're more likely to be the one getting taken advantage of.


(EDIT: archive.org archive link to "The Inefficient Market Argument for Passive Investing"
https://web.archive.org/web/20150325013 ... ssive.html
Last edited by JoMoney on Sun Jun 13, 2021 7:59 am, edited 1 time in total.
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Re: Is market capitalization the correct metric?

Post by Robot Monster »

David Jay wrote: Sat Jun 12, 2021 12:45 pm
vineviz wrote: Sat Jun 12, 2021 12:11 pm
nisiprius wrote: Sat Jun 12, 2021 9:25 am But it is not the case that cap-weighting is just some arbitrary choice, not just a matter of opinion. The Leaning Tower may have good properties, but it is the tower that leans, not the plumb line. Cap-weighting is the plumb line.
The market cap weighted portfolio is indeed an "arbitrary choice" in the sense that there is nothing intrinsic to that weighting scheme which makes it superior to any other.
It is not that it is superior, it is the plumb line because the market is what is out there. It is reality, there is nothing "arbitrary" about reality. The market is what the market is. Superior. Inferior. Good. Bad.
If cap-weighing is reality, does that mean equal-weight is fantasy? Sorry, I don't mean to mock. I'm just unsure how to wrap my head around what you're saying. Buying companies according to cap-weight is a choice. Buying them according to equal weight is another choice. Aren't both choices real? :confused
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Re: Is market capitalization the correct metric?

Post by David Jay »

Robot Monster wrote: Sat Jun 12, 2021 1:28 pm
David Jay wrote: Sat Jun 12, 2021 12:45 pm
vineviz wrote: Sat Jun 12, 2021 12:11 pm
nisiprius wrote: Sat Jun 12, 2021 9:25 am But it is not the case that cap-weighting is just some arbitrary choice, not just a matter of opinion. The Leaning Tower may have good properties, but it is the tower that leans, not the plumb line. Cap-weighting is the plumb line.
The market cap weighted portfolio is indeed an "arbitrary choice" in the sense that there is nothing intrinsic to that weighting scheme which makes it superior to any other.
It is not that it is superior, it is the plumb line because the market is what is out there. It is reality, there is nothing "arbitrary" about reality. The market is what the market is. Superior. Inferior. Good. Bad.
If cap-weighing is reality, does that mean equal-weight is fantasy? Sorry, I don't mean to mock. I'm just unsure how to wrap my head around what you're saying. Buying companies according to cap-weight is a choice. Buying them according to equal weight is another choice. Aren't both choices real? :confused
Let's separate your account from the stock market.

The stock market exists. It is cap-weighted - the total value of the stock market is the value of every company's outstanding shares (let's not get into float for simplicity) at their last traded price. That is the definition of cap weighted. That is "what is", in the same sense that gravity exists.

I was responding to the comment that there was something arbitrary about market cap weight. It is not arbitrary, it is definitionally true. That is what makes it a standard by which to compare other equity portfolios. Just like we compare "vertical" to a plumb line. Because gravity is real.

Separately, you can do anything you want in your account. You can own the entire market at cap weight. You can own a portion of the market at equal weight. You can own two or more individual stocks at any weighting you choose.
Last edited by David Jay on Sat Jun 12, 2021 2:01 pm, edited 1 time in total.
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Re: Is market capitalization the correct metric?

Post by Gaston »

jeffyscott wrote: Sat Jun 12, 2021 8:55 am Are you aware of the RAFI indexes, that do weight based on sales, cash flow, dividends, book value?

https://www.researchaffiliates.com/en_u ... index.html
I was not aware of this. Thanks for posting.
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Re: Is market capitalization the correct metric?

Post by Gaston »

Thank you all for your responses.

FYI that I am not challenging the cap weighted approach. But, perhaps like many others, I’ve accepted the approach without thinking much about it, and without knowing WHY it is a good approach. So was hoping to find some academic research that lays out the case.
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Re: Is market capitalization the correct metric?

Post by David Jay »

David Jay wrote: Sat Jun 12, 2021 1:57 pm
Robot Monster wrote: Sat Jun 12, 2021 1:28 pm
David Jay wrote: Sat Jun 12, 2021 12:45 pm
vineviz wrote: Sat Jun 12, 2021 12:11 pm
nisiprius wrote: Sat Jun 12, 2021 9:25 am But it is not the case that cap-weighting is just some arbitrary choice, not just a matter of opinion. The Leaning Tower may have good properties, but it is the tower that leans, not the plumb line. Cap-weighting is the plumb line.
The market cap weighted portfolio is indeed an "arbitrary choice" in the sense that there is nothing intrinsic to that weighting scheme which makes it superior to any other.
It is not that it is superior, it is the plumb line because the market is what is out there. It is reality, there is nothing "arbitrary" about reality. The market is what the market is. Superior. Inferior. Good. Bad.
If cap-weighing is reality, does that mean equal-weight is fantasy? Sorry, I don't mean to mock. I'm just unsure how to wrap my head around what you're saying. Buying companies according to cap-weight is a choice. Buying them according to equal weight is another choice. Aren't both choices real? :confused
Let's separate your account from the stock market.

The stock market exists. It is cap-weighted - the total value of the stock market is the value of every company's outstanding shares (let's not get into float for simplicity) at their last traded price. That is the definition of cap weighted. That is "what is", in the same sense that gravity exists.

I was responding to the comment that there was something arbitrary about market cap weight. It is not arbitrary, it is definitionally true. That is what makes it a standard by which to compare other equity portfolios. Just like we compare "vertical" to a plumb line. Because gravity is real.

Separately, you can do anything you want in your account. You can own the entire market at cap weight. You can own a portion of the market at equal weight. You can own two or more individual stocks at any weighting you choose.
I see where some of the confusion arises. Nisiprius was talking about cap-weighting. Vineviz inserted the words "portfolio" in his reply. I missed that and I was still working off of Nisiprius' original thought when I replied to Vineviz.

My comment would have been more clear if the Vineviz quote wasn't in my post. But then I would not have responded to Vineviz. Which would have prevented any confusion on your part. Oh, well... :oops:
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Re: Is market capitalization the correct metric?

Post by vineviz »

David Jay wrote: Sat Jun 12, 2021 12:45 pm It is not that it is superior, it is the plumb line because the market is what is out there. It is reality, there is nothing "arbitrary" about reality. The market is what the market is. Superior. Inferior. Good. Bad.
Sure. The market is the market. But the question is whether the market is a good “portfolio” for investors.

Then it’s just one portfolio among many.
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Re: Is market capitalization the correct metric?

Post by ruud »

Robot Monster wrote: Sat Jun 12, 2021 1:28 pm If cap-weighing is reality, does that mean equal-weight is fantasy?
At scale, yes. Imagine for a moment that VTSAX was equal-weighted instead of cap-weighted.

Instead of holding $56 billion in AAPL and $4.5 million in LCI (Lannett Co. Inc.), it would have to hold $326 million in each. That's more than the entire market cap of Lannett.

(I just happened to pick that stock as it is the #3000 holding of VTSAX)
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Re: Is market capitalization the correct metric?

Post by ivgrivchuck »

Gaston wrote: Sat Jun 12, 2021 2:05 pm Thank you all for your responses.

FYI that I am not challenging the cap weighted approach. But, perhaps like many others, I’ve accepted the approach without thinking much about it, and without knowing WHY it is a good approach. So was hoping to find some academic research that lays out the case.
It is hard to find academic research on elementary topics.

1) market cap weighted portfolio is how an average market participant invests.
2) Choosing some other portfolio means overweighting some stocks and underweighting others relative to other market participants.
3) If this is indeed a superior way to invest, all other rational market participants will start to do the same, driving up the price of overweighted stocks and drinving down the price of underweighted stocks.
4) The process continues until the new superior way to invest is identical to the market cap weighted portfolio.

Hence if you support the efficient market hypothesis, the only rational reason to deviate from the market cap weighted portfolio is if your investment objectives significantly differ from the market average (for example you want to minimize volatility)

I don't think that there is much else to say...
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Re: Is market capitalization the correct metric?

Post by Robot Monster »

ruud wrote: Sat Jun 12, 2021 2:32 pm
Robot Monster wrote: Sat Jun 12, 2021 1:28 pm If cap-weighing is reality, does that mean equal-weight is fantasy?
At scale, yes. Imagine for a moment that VTSAX was equal-weighted instead of cap-weighted.

Instead of holding $56 billion in AAPL and $4.5 million in LCI (Lannett Co. Inc.), it would have to hold $326 million in each. That's more than the entire market cap of Lannett.

(I just happened to pick that stock as it is the #3000 holding of VTSAX)
Hmn, interesting. Is that why equal weight only exists for the S&P, I wonder.
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Re: Is market capitalization the correct metric?

Post by NiceUnparticularMan »

ivgrivchuck wrote: Sat Jun 12, 2021 2:36 pmHence if you support the efficient market hypothesis, the only rational reason to deviate from the market cap weighted portfolio is if your investment objectives significantly differ from the market average (for example you want to minimize volatility)

I don't think that there is much else to say...
Just to be clear about something, this is true as long as you have a broad definition of investment objectives, including seeking and not just avoiding different risks. So, if you believe there is a certain risk premium and you as a personal investor want more exposure to that risk premium than the average market participant, that could be a reason to depart from market cap weighting.

I note this because the goal in that case could also be framed as seeking a higher expected return, which sounds like an objective all market investors would share. But as long as you assume that higher expected return comes as a result of some sort of higher risk (and not just volatility), then you are not assuming a violation of the efficient markets hypothesis.
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Re: Is market capitalization the correct metric?

Post by David Jay »

Robot Monster wrote: Sat Jun 12, 2021 4:54 pm
ruud wrote: Sat Jun 12, 2021 2:32 pm
Robot Monster wrote: Sat Jun 12, 2021 1:28 pm If cap-weighing is reality, does that mean equal-weight is fantasy?
At scale, yes. Imagine for a moment that VTSAX was equal-weighted instead of cap-weighted.

Instead of holding $56 billion in AAPL and $4.5 million in LCI (Lannett Co. Inc.), it would have to hold $326 million in each. That's more than the entire market cap of Lannett.

(I just happened to pick that stock as it is the #3000 holding of VTSAX)
Hmn, interesting. Is that why equal weight only exists for the S&P, I wonder.
That’s part of it. The other part is that equal weight is high effort (and turnover expense) to maintain. It requires continuous rebalancing, as the market is always “messing” with your allocation.

Wells Fargo discovered this with the first ever S&P 500 fund (which closed). Bogle’s innovation was the cap-weighted S&P 500 fund, which was a resounding success. If you hold at market weight, you don’t have to make any changes is response to market moves.
Last edited by David Jay on Sun Jun 13, 2021 8:31 am, edited 1 time in total.
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Re: Is market capitalization the correct metric?

Post by ivgrivchuck »

NiceUnparticularMan wrote: Sun Jun 13, 2021 4:13 am
ivgrivchuck wrote: Sat Jun 12, 2021 2:36 pmHence if you support the efficient market hypothesis, the only rational reason to deviate from the market cap weighted portfolio is if your investment objectives significantly differ from the market average (for example you want to minimize volatility)

I don't think that there is much else to say...
Just to be clear about something, this is true as long as you have a broad definition of investment objectives, including seeking and not just avoiding different risks. So, if you believe there is a certain risk premium and you as a personal investor want more exposure to that risk premium than the average market participant, that could be a reason to depart from market cap weighting.

I note this because the goal in that case could also be framed as seeking a higher expected return, which sounds like an objective all market investors would share. But as long as you assume that higher expected return comes as a result of some sort of higher risk (and not just volatility), then you are not assuming a violation of the efficient markets hypothesis.
I believe you are referring to small-value investing (or using factors). That is indeed an interesting case!

The value of those factors definitely went down when they became public knowledge. However most academics still agree that they are still there.

I believe that this comes from the fact that not everybody has fully bought the idea, or does not want those additional risk factors for correct or incorrect reasons. So there is potentially there is some extra to be made for those who do.

Or it is possible that the impact of factors have practically already disappeared. The challenge is that we wont know until 40 years from now...
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Re: Is market capitalization the correct metric?

Post by jeffyscott »

David Jay wrote: Sun Jun 13, 2021 7:34 am
Robot Monster wrote: Sat Jun 12, 2021 4:54 pm
ruud wrote: Sat Jun 12, 2021 2:32 pm
Robot Monster wrote: Sat Jun 12, 2021 1:28 pm If cap-weighing is reality, does that mean equal-weight is fantasy?
At scale, yes. Imagine for a moment that VTSAX was equal-weighted instead of cap-weighted.

Instead of holding $56 billion in AAPL and $4.5 million in LCI (Lannett Co. Inc.), it would have to hold $326 million in each. That's more than the entire market cap of Lannett.

(I just happened to pick that stock as it is the #3000 holding of VTSAX)
Hmn, interesting. Is that why equal weight only exists for the S&P, I wonder.
That’s part of it. The other part is that equal weight is high effort (and turnover expense) to maintain. It requires continuous rebalancing, as the market is always “messing” with your allocation.

Wells Fargo discovered this with the first ever S&P 500 fund (which closed). Bogle’s innovation was the cap-weighted S&P 500 fund, which was a resounding success. If you hold at market weight, you don’t have to make any changes is response to market moves.
It doesn't appear that it has to be very costly to do equal weight, at least for large caps. It may not be using the S&P 500, but Goldman Sachs Equal Weight U.S. Large Cap (GSEW) has an ER of 0.09%.

Invesco apparently offers equal weight ETFs based on the S&P small cap and mid cap indexes, so it's possible to run equal weight even in small caps. Obviously, these funds can not become as large as VTSAX.
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Re: Is market capitalization the correct metric?

Post by acegolfer »

Gaston wrote: Sat Jun 12, 2021 8:33 am When it comes to the indices that track large segments or all segments of a market (S&P 500, total stock market, etc), my understanding is that those indices weight companies on market cap. Is there any research, however, demonstrating that, from an investor point of view, market cap is the best weighting approach?

There is an infinite number of ways that an index could weight its component stocks, such as by net sales, by price-to-book ratio, by the number of vowels in each company's name, etc. So how do we know that market cap provides the best basis for investor decisions?

And yes, I am aware that if one wants to segment the market, one can find indices that tilt toward growth v value, large cap v small cap, or technology v consumer discretionary, among many others. But to be clear, that's not what I'm talking about here. I'm not asking about segmenting the market; I'm wondering whether the use of market cap, as the weighting methodology in total market indices, best serves the investor.

If anyone knows of reliable research on this topic, I would appreciate if you could post a source or a link. Thx.
This was mathematically proven in 60s by Prof Sharpe. Google "CAPM" and learn why market portfolio has the highest expected return for a given risk (iow, efficient portfolio).
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Re: Is market capitalization the correct metric?

Post by JoMoney »

acegolfer wrote: Sun Jun 13, 2021 9:52 am...
This was mathematically proven in 60s by Prof Sharpe. Google "CAPM" and learn why market portfolio has the highest expected return for a given risk (iow, efficient portfolio).
... only "proven" under modeled assumptions like the market being efficient with rational agents and that standard deviation was a good proxy for measuring the risk the efficient market is pricing.
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Re: Is market capitalization the correct metric?

Post by nisiprius »

Robot Monster wrote: Sat Jun 12, 2021 4:54 pm
ruud wrote: Sat Jun 12, 2021 2:32 pm
Robot Monster wrote: Sat Jun 12, 2021 1:28 pm If cap-weighing is reality, does that mean equal-weight is fantasy?
At scale, yes. Imagine for a moment that VTSAX was equal-weighted instead of cap-weighted.

Instead of holding $56 billion in AAPL and $4.5 million in LCI (Lannett Co. Inc.), it would have to hold $326 million in each. That's more than the entire market cap of Lannett.

(I just happened to pick that stock as it is the #3000 holding of VTSAX)
Hmn, interesting. Is that why equal weight only exists for the S&P, I wonder.
Dunno. It is probably a factor.

A few years ago there was actually an ETF, EWRS, misleadingly named the Guggenheim Equal Weight Russell 2000. (I'll get to "misleadingly" later). It is significant that it got very little love from equal weight fans. It's worth noting that if you equal-weighted the whole stock market, then to a close approximation that would be the same as just the 2,500 small- and mid-caps that are not in the S&P 500 and leaving out the S&P 500 entirely. That's what the "logic" of equal weighting leads to, a very heavy tilt to small-caps.

EWRS was introduced in late 2010 and liquidated in March 2014. I find it hard to get data on shuttered funds and ETFs. I seem to remember that it had had fairly bad performance.

I don't know what challenges "equal weighting" posed, but EQRS was far from what you would expect from the name. It tracked the IMHO-also-misleadingly-named Equal Weight Russell 2000 index, which equalizes in two layers. First, it devotes equal weight to each sector. Then it equal-weights the stocks within each sector. It still poses the operational problem of buying large amounts of very small stocks.

They also offered EWRI, an "Equal Weight Russell 1000 index." Logically, an equal weight fan should have been interested in 33.3% EWRI, 66.7% EWRS, but I don't remember anyone ever suggesting it.
Last edited by nisiprius on Sun Jun 13, 2021 8:42 pm, edited 2 times in total.
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Re: Is market capitalization the correct metric?

Post by bikeeagle1 »

To the OP, I applaud you for trying to think outside the box. I always love it when somebody asks a question that hasn't been asked before, or even an old question looked at in a new way.

Just off the top of my head, if "market cap" represents the current combined opinion of all investors, then perhaps "book value" would be a better way to weight an index, if one is attempting to remove the noise of minute-by-minute news?

That gives me an idea. Has anyone attempted to plot the ratio of market value to book value for the S&P over time? That might be a good way to measure whether and how much the market is overvalued. As with the OP, I'm just trying to think outside the box.

Thanks to google, here's the answer (it's currently near its ATH):

https://www.multpl.com/s-p-500-price-to-book

If this ratio were to fall to its 20-year average of 2.87, that would mean SPX would be at 2,661, a drop of 37% from its current level (4,247).
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Re: Is market capitalization the correct metric?

Post by Gaston »

bikeeagle1 wrote: Sun Jun 13, 2021 11:35 am https://www.multpl.com/s-p-500-price-to-book

If this ratio were to fall to its 20-year average of 2.87, that would mean SPX would be at 2,661, a drop of 37% from its current level (4,247).
Ouch.
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Re: Is market capitalization the correct metric?

Post by David Jay »

jeffyscott wrote: Sun Jun 13, 2021 9:39 am
David Jay wrote: Sun Jun 13, 2021 7:34 am
Robot Monster wrote: Sat Jun 12, 2021 4:54 pm
ruud wrote: Sat Jun 12, 2021 2:32 pm
Robot Monster wrote: Sat Jun 12, 2021 1:28 pm If cap-weighing is reality, does that mean equal-weight is fantasy?
At scale, yes. Imagine for a moment that VTSAX was equal-weighted instead of cap-weighted.

Instead of holding $56 billion in AAPL and $4.5 million in LCI (Lannett Co. Inc.), it would have to hold $326 million in each. That's more than the entire market cap of Lannett.

(I just happened to pick that stock as it is the #3000 holding of VTSAX)
Hmn, interesting. Is that why equal weight only exists for the S&P, I wonder.
That’s part of it. The other part is that equal weight is high effort (and turnover expense) to maintain. It requires continuous rebalancing, as the market is always “messing” with your allocation.

Wells Fargo discovered this with the first ever S&P 500 fund (which closed). Bogle’s innovation was the cap-weighted S&P 500 fund, which was a resounding success. If you hold at market weight, you don’t have to make any changes is response to market moves.
It doesn't appear that it has to be very costly to do equal weight, at least for large caps. It may not be using the S&P 500, but Goldman Sachs Equal Weight U.S. Large Cap (GSEW) has an ER of 0.09%.

Invesco apparently offers equal weight ETFs based on the S&P small cap and mid cap indexes, so it's possible to run equal weight even in small caps. Obviously, these funds can not become as large as VTSAX.
To my point about greater tax expense from turnover, the Morningstar Tax Expense ratio for GSEW is .6, for VFIAX (SP500 market weight) is .45, so the equal weight is a third greater than the market weight. I wouldn't recommend equal weight in taxable.
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Re: Is market capitalization the correct metric?

Post by Northern Flicker »

Gaston wrote: When it comes to the indices that track large segments or all segments of a market (S&P 500, total stock market, etc), my understanding is that those indices weight companies on market cap. Is there any research, however, demonstrating that, from an investor point of view, market cap is the best weighting approach?
Best to achieve what goal? Cap-weighting avoids the need to rebalance the portfolio in response to market action. Float-adjusted cap-weighted portfolios need to be rebalanced when a float changes. Float-adjusted cap-weighted indices hold stocks in proportion to their liquidity. Cap-weighted indices approximately hold stocks in proportion to their liquidity.

The above are all objective advantages. The other property of cap-weighting is that it fully diversifies away risk other than market risk. You take market risk, and get market return. Other weightings take on exposure to other risk factors, which may be systematic, and compensated with additional expected return, or may be uncompensated, idiosyncratic risk.
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Re: Is market capitalization the correct metric?

Post by stockmantim »

Another thing to consider in this conversation is that market cap is only the equity portion of a business' capital structure (i.e., if a business is worth $100, then if it is debt free the market cap is $100, while if it has $50 of debt the market cap is $50). While many businesses that are similar in nature have similar capital structure, it may be an interesting intellectual question to investigate whether we should un-lever equities and then do an EV weighted fund with debt applied. This would (relative to today) shift the allocation of funds away from tech (low D/EV) and towards things that have lots of debt. It would also, arguably, make the portfolio look more like the broader economy.

No answer here, just thinking aloud.
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Re: Is market capitalization the correct metric?

Post by Tingting1013 »

stockmantim wrote: Mon Jun 14, 2021 8:38 pm Another thing to consider in this conversation is that market cap is only the equity portion of a business' capital structure (i.e., if a business is worth $100, then if it is debt free the market cap is $100, while if it has $50 of debt the market cap is $50). While many businesses that are similar in nature have similar capital structure, it may be an interesting intellectual question to investigate whether we should un-lever equities and then do an EV weighted fund with debt applied. This would (relative to today) shift the allocation of funds away from tech (low D/EV) and towards things that have lots of debt. It would also, arguably, make the portfolio look more like the broader economy.

No answer here, just thinking aloud.
Why wouldn’t you just get corporate debt exposure via a bond index fund?
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Re: Is market capitalization the correct metric?

Post by nisiprius »

Gaston wrote: Sat Jun 12, 2021 8:33 am...If anyone knows of reliable research on this topic, I would appreciate if you could post a source or a link...
This seems to be a reasonable exposition of the theory behind it. Mean-Variance Portfolio Theory

This seems to be standard, accepted classroom/textbook stuff in financial economics. What it means in the real world depends on how close the real world is to the assumptions and how sensitive the results are to small departures from the assumptions. Siegel, for example, in Stocks for the Long Run accepts it as legitimate, and then says that fundamental indexing is better because he himself espouses a "noisy market hypothesis" which differs from the assumptions and leads to a different optimum weighting.

The math is just slightly beyond my own understanding, but you can read the conclusions and then try to back up and figure out the assumptions that lead to them.

Notice that although the presentation uses the word "efficient" in a technical sense in financial economics, the phrases "efficient market" and "efficient market hypothesis" do not appear. The conclusion does not depend on the market itself being efficient.

Notice the presentation in the last few paragraphs near the end:
Interpretation of the tangency portfolio (market portfolio)
  • One-fund theorem states that everyone will purchase a single fund of risky assets and borrow or lend at the risk free rate.
  • If everyone purchases the same fund of risky assets, what must that fund be? This fund must equal the market portfolio.
  • The market portfolio is the summation of all assets. If everyone buys just one fund, and their purchases add up to the market, then that one fund must be the market as well.
  • In the situation where everyone follows the mean-variance method- ology with the same estimates of parameters, the efficient fund of risky assets will be the market portfolio.
How does this happen? The answer is based on the equilibrium argument.
  • If everyone else (or at least a large number of people) solves the problem, we do not need to. The return on an asset depends on both its initial price and its final price. The other investors solve the mean-variance portfolio problem using their common estimates, and they place orders in the market to acquire their portfolios.
  • If orders placed do not match what is available, the prices must change. The prices of assets under heavy demand will increase; the prices of assets under light demand will decrease. These price changes affect the estimates of asset returns directly, and hence investors will recalculate their optimal portfolio.
  • This process continues until demand exactly matches supply; that is, it continues until there is equilibrium.
Summary
  • In the idealized world, where every investor is a mean-variance investor and all have the same estimates, everyone buys the same portfolio, and that must be equal to the market portfolio.
  • Prices adjust to drive the market to efficiency. Then after other people have made the adjustments, we can be sure that the efficient portfolio is the market portfolio, so we need not make any calculations.
This does not mean that a cap-weighted total market index fund is the best investment in the real world, but it does explain why it has a special status and is the "level" from which we measure "tilts," and is not just an arbitrary choice. It's like the use of frictionless planes in physics, or points with no area in geometry.
Last edited by nisiprius on Tue Jun 15, 2021 7:38 am, edited 2 times in total.
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Re: Is market capitalization the correct metric?

Post by nisiprius »

stockmantim wrote: Mon Jun 14, 2021 8:38 pm Another thing to consider in this conversation is that market cap is only the equity portion of a business' capital structure (i.e., if a business is worth $100, then if it is debt free the market cap is $100, while if it has $50 of debt the market cap is $50). While many businesses that are similar in nature have similar capital structure, it may be an interesting intellectual question to investigate whether we should un-lever equities and then do an EV weighted fund with debt applied. This would (relative to today) shift the allocation of funds away from tech (low D/EV) and towards things that have lots of debt. It would also, arguably, make the portfolio look more like the broader economy.

No answer here, just thinking aloud.
The theory that arrives at market capitalization as a mean-variance optimum doesn't look at what is behind prices or volatility. It assumes that the price and volatility of stocks are whatever they are, and asks the question, given those prices and volatility, and given some strong assumptions about how investors behave, what portfolio has the highest possible risk-adjusted return? It turns out to be "the market portfolio" itself, or a cap-weighted portfolio that is a miniaturized replica of the whole market.

So it does not affect the theory to analyze what characteristics might underly the price and volatility of stocks. Your analysis is just a special case of all attempts to beat market-cap weighting by finding inefficiencies.

If you can find a magic formula (like the literal Greenblatt "Magic Formula!") that consistently judges stocks better than the rest of the market, then of course you can beat the market. People have been searching for that for a long time.

The comment about "making the portfolio look more like the broader economy" is interesting because that is often suggested without any rationale as a desirable thing. People pushing emerging markets say "your (cap-weighted total world market portfolio) doesn't look like the world economy," people pushing small-caps will say "small businesses are much more important in the real economy than they are in a cap-weighted index," etc. When I've seen remarks like that, they always begs the question, i.e. it's phrased as a criticism--your portfolio doesn't match the economy--with an insinuation that it should. But it's only an insinuation, no reasons are given.
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Re: Is market capitalization the correct metric?

Post by jeffyscott »

nisiprius wrote: Tue Jun 15, 2021 6:18 am Notice the presentation in the last few paragraphs near the end:
Interpretation of the tangency portfolio (market portfolio)
  • One-fund theorem states that everyone will purchase a single fund of risky assets and borrow or lend at the risk free rate.
  • If everyone purchases the same fund of risky assets, what must that fund be? This fund must equal the market portfolio.
  • The market portfolio is the summation of all assets. If everyone buys just one fund, and their purchases add up to the market, then that one fund must be the market as well.
  • In the situation where everyone follows the mean-variance method- ology with the same estimates of parameters, the efficient fund of risky assets will be the market portfolio.
My understanding is that this "market portfolio of risky assets" is not restricted to stocks. At a minimum, it would also include all fixed-income investments, other than the "risk-free asset" (T-bills).

Investing in the global market portfolio would likely mean being fairly close to 50/50 stocks/bonds and 50/50 US/International
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Re: Is market capitalization the correct metric?

Post by NiceUnparticularMan »

jeffyscott wrote: Tue Jun 15, 2021 7:51 am
nisiprius wrote: Tue Jun 15, 2021 6:18 am Notice the presentation in the last few paragraphs near the end:
Interpretation of the tangency portfolio (market portfolio)
  • One-fund theorem states that everyone will purchase a single fund of risky assets and borrow or lend at the risk free rate.
  • If everyone purchases the same fund of risky assets, what must that fund be? This fund must equal the market portfolio.
  • The market portfolio is the summation of all assets. If everyone buys just one fund, and their purchases add up to the market, then that one fund must be the market as well.
  • In the situation where everyone follows the mean-variance method- ology with the same estimates of parameters, the efficient fund of risky assets will be the market portfolio.
My understanding is that this "market portfolio of risky assets" is not restricted to stocks. At a minimum, it would also include all fixed-income investments, other than the "risk-free asset" (T-bills).

Investing in the global market portfolio would likely mean being fairly close to 50/50 stocks/bonds and 50/50 US/International
viewtopic.php?p=5283307#p5283307
It gets even trickier when you realize the logic isn't really limited to just exchanged-traded risky assets. Entities can buy risky assets in other ways, and they do, and presumably those same entities then account for those non-exchange-traded assets when buying exchange-traded assets and assembling the actual market portfolio.

All this is part of why I can both accept the premise that a cap-weighted portfolio of global stocks is part of an efficient portfolio of risky assets, and also not be concerned that I personally don't invest in stocks that way. Because I am not even attempting to buy whatever would truly be the full portfolio of investable assets.
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Re: Is market capitalization the correct metric?

Post by Astones »

When you weight according to market cap, your weights will move together with the market fluctuations, without the need of adjustments on your part.

For any other metric you'll have to re-weight every now and then because your weights will not move together with the underlying securities, and pay for the corresponding transaction costs.
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Re: Is market capitalization the correct metric?

Post by Ben Mathew »

jeffyscott wrote: Tue Jun 15, 2021 7:51 am
nisiprius wrote: Tue Jun 15, 2021 6:18 am Notice the presentation in the last few paragraphs near the end:
Interpretation of the tangency portfolio (market portfolio)
  • One-fund theorem states that everyone will purchase a single fund of risky assets and borrow or lend at the risk free rate.
  • If everyone purchases the same fund of risky assets, what must that fund be? This fund must equal the market portfolio.
  • The market portfolio is the summation of all assets. If everyone buys just one fund, and their purchases add up to the market, then that one fund must be the market as well.
  • In the situation where everyone follows the mean-variance method- ology with the same estimates of parameters, the efficient fund of risky assets will be the market portfolio.
My understanding is that this "market portfolio of risky assets" is not restricted to stocks. At a minimum, it would also include all fixed-income investments, other than the "risk-free asset" (T-bills).

Investing in the global market portfolio would likely mean being fairly close to 50/50 stocks/bonds and 50/50 US/International
viewtopic.php?p=5283307#p5283307
Yes, ideally the market portfolio would include corporate bonds. Then people who want to hold a riskier portfolio than this market portfolio would then have to borrow at the risk free rate and leverage this market portfolio. Since we can't borrow at the risk free rate, we are simply approximating this by achieving our target by dropping corporate bonds from the market portfolio.

According to Prof. Campbell:
Corporate bonds are certainly in the market portfolio, but the conventional view is that adding them does not make much difference empirically.
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Re: Is market capitalization the correct metric?

Post by nisiprius »

jeffyscott wrote: Tue Jun 15, 2021 7:51 amMy understanding is that this "market portfolio of risky assets" is not restricted to stocks. At a minimum, it would also include all fixed-income investments, other than the "risk-free asset" (T-bills).
The theory applies to investors trading within a single "market," whatever that means. Maybe someone who knows financial economics can tell us what a "market" is. It certainly implies something about frictionless trading and the ability of the assets within it to equilibrate. Is "the stock market" and "the bond market" a single market? Are meats traded on the Chicago Mercantile Exchange in equilibrium with stocks traded in the Szenzhen Stock Market? Are you aware of any exchange-traded products that hold both physical lithium and SPACs?
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Re: Is market capitalization the correct metric?

Post by Ben Mathew »

NiceUnparticularMan wrote: Tue Jun 15, 2021 8:45 am
jeffyscott wrote: Tue Jun 15, 2021 7:51 am
nisiprius wrote: Tue Jun 15, 2021 6:18 am Notice the presentation in the last few paragraphs near the end:
Interpretation of the tangency portfolio (market portfolio)
  • One-fund theorem states that everyone will purchase a single fund of risky assets and borrow or lend at the risk free rate.
  • If everyone purchases the same fund of risky assets, what must that fund be? This fund must equal the market portfolio.
  • The market portfolio is the summation of all assets. If everyone buys just one fund, and their purchases add up to the market, then that one fund must be the market as well.
  • In the situation where everyone follows the mean-variance method- ology with the same estimates of parameters, the efficient fund of risky assets will be the market portfolio.
My understanding is that this "market portfolio of risky assets" is not restricted to stocks. At a minimum, it would also include all fixed-income investments, other than the "risk-free asset" (T-bills).

Investing in the global market portfolio would likely mean being fairly close to 50/50 stocks/bonds and 50/50 US/International
viewtopic.php?p=5283307#p5283307
It gets even trickier when you realize the logic isn't really limited to just exchanged-traded risky assets. Entities can buy risky assets in other ways, and they do, and presumably those same entities then account for those non-exchange-traded assets when buying exchange-traded assets and assembling the actual market portfolio.

All this is part of why I can both accept the premise that a cap-weighted portfolio of global stocks is part of an efficient portfolio of risky assets, and also not be concerned that I personally don't invest in stocks that way. Because I am not even attempting to buy whatever would truly be the full portfolio of investable assets.
You're right that even if markets are efficient, since publicly traded assets are not all assets, we can in principle tweak things and do better. Maybe hotel owners should own less hotel stocks. Maybe bankers should hold less bank stocks and doctors should hold less healthcare stocks. That would require estimating correlations of each stock or maybe sector with our non-market income and do some Markowitz style optimal portfolio construction. That's tough, especially since there's so much uncertainty about these correlations.

IMO, if the market is efficient, the traded-assets portfolio is good enough for almost everyone. If it's not efficient, then that opens the door to tilts.
Last edited by Ben Mathew on Tue Jun 15, 2021 1:41 pm, edited 1 time in total.
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Re: Is market capitalization the correct metric?

Post by Ben Mathew »

nisiprius wrote: Tue Jun 15, 2021 11:41 am
jeffyscott wrote: Tue Jun 15, 2021 7:51 amMy understanding is that this "market portfolio of risky assets" is not restricted to stocks. At a minimum, it would also include all fixed-income investments, other than the "risk-free asset" (T-bills).
The theory applies to investors trading within a single "market," whatever that means. Maybe someone who knows financial economics can tell us what a "market" is. It certainly implies something about frictionless trading and the ability of the assets within it to equilibrate. Is "the stock market" and "the bond market" a single market? Are meats traded on the Chicago Mercantile Exchange in equilibrium with stocks traded in the Szenzhen Stock Market? Are you aware of any exchange-traded products that hold both physical lithium and SPACs?
The bolded part above is key. We can consider it a single market if the law of one price holds--i.e. price differences can't persist. And price differences can't persist if enough people can arbitrage across these markets. I would say that all of the financial markets you mentioned above can be thought of as a single market.
NiceUnparticularMan
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Re: Is market capitalization the correct metric?

Post by NiceUnparticularMan »

Ben Mathew wrote: Tue Jun 15, 2021 12:10 pm
NiceUnparticularMan wrote: Tue Jun 15, 2021 8:45 am
jeffyscott wrote: Tue Jun 15, 2021 7:51 am
nisiprius wrote: Tue Jun 15, 2021 6:18 am Notice the presentation in the last few paragraphs near the end:
Interpretation of the tangency portfolio (market portfolio)
  • One-fund theorem states that everyone will purchase a single fund of risky assets and borrow or lend at the risk free rate.
  • If everyone purchases the same fund of risky assets, what must that fund be? This fund must equal the market portfolio.
  • The market portfolio is the summation of all assets. If everyone buys just one fund, and their purchases add up to the market, then that one fund must be the market as well.
  • In the situation where everyone follows the mean-variance method- ology with the same estimates of parameters, the efficient fund of risky assets will be the market portfolio.
My understanding is that this "market portfolio of risky assets" is not restricted to stocks. At a minimum, it would also include all fixed-income investments, other than the "risk-free asset" (T-bills).

Investing in the global market portfolio would likely mean being fairly close to 50/50 stocks/bonds and 50/50 US/International
viewtopic.php?p=5283307#p5283307
It gets even trickier when you realize the logic isn't really limited to just exchanged-traded risky assets. Entities can buy risky assets in other ways, and they do, and presumably those same entities then account for those non-exchange-traded assets when buying exchange-traded assets and assembling the actual market portfolio.

All this is part of why I can both accept the premise that a cap-weighted portfolio of global stocks is part of an efficient portfolio of risky assets, and also not be concerned that I personally don't invest in stocks that way. Because I am not even attempting to buy whatever would truly be the full portfolio of investable assets.
You're right that even if markets are efficient, since publicly traded assets are not all assets, we can in principle tweak things and do better. Maybe bankers should hold less bank stocks and doctors should hold less healthcare stocks. That would require estimating correlations of each stock or maybe sector with our non-market income and do some Markowitz style optimal portfolio construction. That's tough, especially since there's so much uncertainty about these correlations.

IMO, if the market is efficient, the traded-assets portfolio is good enough for almost everyone. If it's not efficient, then that opens the door to tilts.
So one important observation is there are many more entities in the markets than just personal investors. Endowments, pension funds, corporations, governments, and so on are buying a large variety of assets in the financial markets in light of their other assets and liabilities, including their other sources of revenue, debt they have taken on, and so on.

And I think once you understand that, the idea there would be just "tweaks" between what the summation of those entities would buy and what it makes sense for any one entity, including a personal investor, to buy might not seem so plausible. Indeed, in practice many of those entities don't remotely have portfolios like each other, which of course makes sense when you consider the totality of their financial circumstances.

With respect to stocks, and just by way of example, one possible explanation of some "factors" are there are adverse correlations between factor returns and other macroeconomic events that may affect other revenues, including revenues from tuition, new contributions, sales, taxes, and so on. The personal investor equivalent of this might be they could affect income from wages.

Even just among themselves, different households might have different correlated income risk, including just because some households have more than one job. As in, you mentioned a banker, and a doctor, but then there are also household with bankers married to doctors, and so on.

Or households early in accumulation, late in accumulation, or in retirement. All those might have very different implications for correlated wage risk.

And then compared to actual banks? Hospitals? And on and on through all the other participants in financial markets?

Given all this, I actually don't think it is implausible at all that personal investors could rationally have very different "efficient" exposures to relevant factors from each other, and then even more so from other types of entities, just as those other entities vary from each other.

That said, I agree if you don't know how to vary from the market portfolio's exposure to such risks, you can just view that as a default. I just don't think you need to see that as indicating departures would necessarily be inefficient for a variety of entities including personal investors. It is just if you don't know which way to depart in your specific case, you might as well do the easy and low-cost thing and be done with it.
NiceUnparticularMan
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Re: Is market capitalization the correct metric?

Post by NiceUnparticularMan »

Ben Mathew wrote: Tue Jun 15, 2021 12:19 pm
nisiprius wrote: Tue Jun 15, 2021 11:41 am
jeffyscott wrote: Tue Jun 15, 2021 7:51 amMy understanding is that this "market portfolio of risky assets" is not restricted to stocks. At a minimum, it would also include all fixed-income investments, other than the "risk-free asset" (T-bills).
The theory applies to investors trading within a single "market," whatever that means. Maybe someone who knows financial economics can tell us what a "market" is. It certainly implies something about frictionless trading and the ability of the assets within it to equilibrate. Is "the stock market" and "the bond market" a single market? Are meats traded on the Chicago Mercantile Exchange in equilibrium with stocks traded in the Szenzhen Stock Market? Are you aware of any exchange-traded products that hold both physical lithium and SPACs?
The bolded part above is key. We can consider it a single market if the law of one price holds--i.e. price differences can't persist. And price differences can't persist if enough people can arbitrage across these markets. I would say that all of the financial markets you mentioned above can be thought of as a single market.
So arbitrage can run into practical liquidity issues. I am not so concerned about individual stocks, bonds, and so on. But suppose the entire $100 trillion U.S. stock market needed to be arbitraged down. Is there enough liquidity to actually pull that off? I'm not sure about that.

In practice, this would mean even if an individual arbitrageur was confident the U.S. stock market as a whole was overpriced, they would not know when, if ever, shorting the whole U.S. stock market would end up paying off. In which case they likely wouldn't even try.
alex_686
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Re: Is market capitalization the correct metric?

Post by alex_686 »

nisiprius wrote: Tue Jun 15, 2021 11:41 am
jeffyscott wrote: Tue Jun 15, 2021 7:51 amMy understanding is that this "market portfolio of risky assets" is not restricted to stocks. At a minimum, it would also include all fixed-income investments, other than the "risk-free asset" (T-bills).
The theory applies to investors trading within a single "market," whatever that means. Maybe someone who knows financial economics can tell us what a "market" is. It certainly implies something about frictionless trading and the ability of the assets within it to equilibrate. Is "the stock market" and "the bond market" a single market? Are meats traded on the Chicago Mercantile Exchange in equilibrium with stocks traded in the Szenzhen Stock Market? Are you aware of any exchange-traded products that hold both physical lithium and SPACs?
In theory it is everything. IIRC it includes real estate, gold, art work, & collectables.

In practice it just includes liquid assets. Or even just the big equity markets. i.e., those which are big and liquid enough to provide high quality pricing data. The more asset classes you add the more complex the model is. Complex models are known to blow up in interesting ways. "Parsimonious" is critical here. I just love that word and concept.

Advance practitioners might included more exotic assets. Clients with large illiquid positions. People peddling private equity funds that invest in art work. The value is debatable.
Former brokerage operations & mutual fund accountant. I hate risk, which is why I study and embrace it.
NiceUnparticularMan
Posts: 2526
Joined: Sat Mar 11, 2017 7:51 am

Re: Is market capitalization the correct metric?

Post by NiceUnparticularMan »

alex_686 wrote: Tue Jun 15, 2021 1:15 pm
nisiprius wrote: Tue Jun 15, 2021 11:41 am
jeffyscott wrote: Tue Jun 15, 2021 7:51 amMy understanding is that this "market portfolio of risky assets" is not restricted to stocks. At a minimum, it would also include all fixed-income investments, other than the "risk-free asset" (T-bills).
The theory applies to investors trading within a single "market," whatever that means. Maybe someone who knows financial economics can tell us what a "market" is. It certainly implies something about frictionless trading and the ability of the assets within it to equilibrate. Is "the stock market" and "the bond market" a single market? Are meats traded on the Chicago Mercantile Exchange in equilibrium with stocks traded in the Szenzhen Stock Market? Are you aware of any exchange-traded products that hold both physical lithium and SPACs?
In theory it is everything. IIRC it includes real estate, gold, art work, & collectables.

In practice it just includes liquid assets. Or even just the big equity markets. i.e., those which are big and liquid enough to provide high quality pricing data. The more asset classes you add the more complex the model is. Complex models are known to blow up in interesting ways. "Parsimonious" is critical here. I just love that word and concept.

Advance practitioners might included more exotic assets. Clients with large illiquid positions. People peddling private equity funds that invest in art work. The value is debatable.
So I think from the perspective of most global investors in asset markets, in practice they very much take a holistic view of their assets and liabilities when purchasing marketed assets.

But I agree a personal investor does not realistically have a way of determining, let alone imitating, what the hypothetical average global investor has in terms of assets and liabilities.

But then the question is--does it make sense for a personal investor to imitate just the part that they can see and imitate? And if that is a very incomplete imitation, then there is no particular reason for that investor to assume by only imitating that part, that they too have an efficient overall financial situation.
alex_686
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Joined: Mon Feb 09, 2015 2:39 pm

Re: Is market capitalization the correct metric?

Post by alex_686 »

NiceUnparticularMan wrote: Tue Jun 15, 2021 1:22 pm But then the question is--does it make sense for a personal investor to imitate just the part that they can see and imitate? And if that is a very incomplete imitation, then there is no particular reason for that investor to assume by only imitating that part, that they too have an efficient overall financial situation.
Maybe. I think it does.

So theory assumes perfect liquidity, information, etc. This is not true, of course. Even if it is mostly true - which I think it is - this leaves grey areas.

I advocate a modest overweight of REITs in the portfolio or around 10% to 20%. Real estate is part of the market basket, a good chunk of real estate is directly held so is not reflected in my traditional market cap indexes. I will acknowledge the shortcomings. Data on real estate is 2nd rate. Public REITs are a imperfect proxy for directly held real estate.

This is a partial answer. 20 years ago the limited data strongly suggested that one should hold REITs due to its low correlation to the overall market. The data today is more mixed.
Former brokerage operations & mutual fund accountant. I hate risk, which is why I study and embrace it.
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