Cap-weighted funds

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boggler
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Cap-weighted funds

Post by boggler » Mon Jul 15, 2013 12:04 am

If Apple were 50% of the US Market cap, would it make sense to invest 50% of one's US stock allocation in it? Perhaps not, right? If so, why do we invest in a cap-weighted manner in the first place, aside from minimizing transaction costs?

durrrr
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Re: Cap-weighted funds

Post by durrrr » Mon Jul 15, 2013 1:21 am

Cap-weighted funds are like capitalism.

It's not perfect, but its there best system there is.

Elbowman
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Re: Cap-weighted funds

Post by Elbowman » Mon Jul 15, 2013 1:31 am

3 out of 10.

Beagler
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Re: Cap-weighted funds

Post by Beagler » Mon Jul 15, 2013 5:40 am

Enron proves your point.
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Rodc
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Re: Cap-weighted funds

Post by Rodc » Mon Jul 15, 2013 9:52 am

I think this is something of a concern. However since such a thing has never occurred, and is very unlikely to occur, it is not a very interesting example.

A different approach, say equal weight, gets around this issue, but introduces other issues. It leads to high transaction and tax costs for one. It also leads to logical inconsistencies (two companies merge and I need to reallocate even though little has really changed). Can't be implemented on the whole market. Etc.

Could just use a cap-weighted mid-cap fund. Company that gets big gets dropped before this problem applies. Low expense rate but more turn over and less tax efficient (I presume). You miss out on companies whose stock has very strong gains, and you are missing a large amount of economic activity by not have large caps.

Or could use a combination of TSM and SC to somewhat mitigate this issue. This may be the best all around approach if this is a major concern. I use an equal mix of TSM and Vanguard SCV (which is more mid-cap than small), but not directly because of this issue.

Over all, while agree it is something to think about, I have posted the same concern in the past, it is unclear that the fix does not introduce more issues than it solves.

TSM is not perfect, but is a pretty darn good approach with many fine properties.
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G-Money
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Re: Cap-weighted funds

Post by G-Money » Mon Jul 15, 2013 10:30 am

boggler wrote:If Apple were 50% of the US Market cap, would it make sense to invest 50% of one's US stock allocation in it?
I'd do it.

The question you posed asks us to assume something that isn't really possible, at least not without some *significant* changes in the US economy. Apple, a large company, but one with limited product lines, currently is about 3% of the US market last I checked. To get to be 50% of the US stock market, Apple would need to merge with:

Exxon
Microsoft ( :) )
GE
Chevron
J&J
Google ( :) )
IBM
Wells Fargo
Proctor & Gamble
Pfizer
AT&T
JPMorgan
Coca-Cola
Philip Morris
Verizon
Merck
Bank of America
Citigroup
Wal-Mart
Oracle
Pepsi
Qualcomm
Cisco
Intel
Home Depot
McDonald's
Schlumberger
Comcast
Amazon
Walt Disney
Berkshire Hathaway
Visa
United Technologies
Amgen
Glead
3M
Altria
ConocoPhillips
CVS Caremark
Bristol-Myers-Squibb
Amex
Union Pacific
Goldman Sachs
AbbVie
US Bancorp
Occidental
eBay
UPS
Boeing

Honestly, I'm not even sure if those companies, with Apple, comprise 50% of TSM. But just imagine how enormously important that single, merged company would be to the US economy. If it went to 0, America as we know it would be fundamentally different. Frankly, the performance of that single company would be an excellent proxy for how the other 50% of the stock market performed.

So no, I wouldn't hesitate to cap weight my investments, even under your somewhat contrived example.
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G-Money
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Re: Cap-weighted funds

Post by G-Money » Mon Jul 15, 2013 10:35 am

Just checked, and the above companies are <40% of the US market (dividing market value of those stocks held in TSM by total fund assets in TSM). So you'd probably need to add another 50-100 companies to that list to hit 50%.

50% of the US stock market is BIG. :)
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Phineas J. Whoopee
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Re: Cap-weighted funds

Post by Phineas J. Whoopee » Mon Jul 15, 2013 11:44 am

boggler wrote:If Apple were 50% of the US Market cap, would it make sense to invest 50% of one's US stock allocation in it? Perhaps not, right? If so, why do we invest in a cap-weighted manner in the first place, aside from minimizing transaction costs?
Hi boggler,

Assuming you're asking about your own portfolio, if you want to invest in an equal-weight fund you are certainly free to do so without boglehead permission.

Assuming you've already done that, why make up a ridiculously unrealistic example to convince everybody else? Anyway, I can out-unrealistic-example you: Let's imagine Apple leveraged its huge pile of money to form a holding company and gain board-level control over every publicly-traded US corporation. Would you want Apple stock, or a cap-weighted index fund that excludes Apple stock, or a simple cap-weighted fund, or an equal-weight fund? Which would be guaranteed to do the best during however long your investing timeline is?

PJW

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nisiprius
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Re: Cap-weighted funds

Post by nisiprius » Mon Jul 15, 2013 11:55 am

boggler wrote:If Apple were 50% of the US Market cap, would it make sense to invest 50% of one's US stock allocation in it?
I think it would. Why wouldn't it? It's hard to think clearly about a situation that's so wildly contrary to fact, of course. But if Apple were half the stock market, Apple would probably be something like half the U.S. economy. I don't buy the idea that a company like GE or Berkshire Hathaway is so diversified that it's "like a mutual fund," but certainly GE and Berkshire Hathaway are more diversified than Barrick Gold or C. R. Bard. In order for Apple to be half the stock market, it would have to be more than a high-tech gadget maker; it would have to be a heck of a lot more diversified than GE or Berkshire Hathaway.
Perhaps not, right? If so, why do we invest in a cap-weighted manner in the first place, aside from minimizing transaction costs?
Because, according to Jeremy SIegel, in Stocks for the Long Run,
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.
In early editions he just said that and let it go. In later editions, after he became associated with WisdomTree and non-cap-weighted "fundamental indexes," he followed that statement by saying that he doesn't think those assumptions are realistic. Nevertheless, whether you choose to accept it or not, it is a valid rationale. Furthermore, while he does not think the assumptions are strictly accurate, he obviously thinks they are close to accurate, because his fundamental indexes are relatively small adjustments or corrections to cap-weighted indexes.

Keep in mind, boggler, that although it is now very popular to take potshots at cap-weighting, you need to take account of where the critics are coming from. If you want to make some money in the mutual fund or ETF business, what are you going to do? Actively managed funds are currently losing ground, there is a definite shift toward indexing. But the territory of low-cost cap-weighted index funds is already pretty much occupied, between Vanguard and some other providers. We already have all the cap-weighted index funds we need. And the other providers may be losing money on them, or at least not making enough to keep their enterprises afloat and pay profits to their shareholders, because they can't get their costs down as low as Vanguard. So if your active funds are dying, you certainly don't want to try to introduce new cap-weighted funds.

The obvious strategy is to introduce index funds with a twist, index funds that aren't cap-weighted, index funds that have low enough costs, maybe 0.30% to 0.50% or so, that people will accept them as "low-cost index funds," but better then those old-fashioned, passé cap-weighted funds. So, they are going to attack cap-weighting.

I am not convinced that cap-weighted index funds are any better than indexes-with-a-twist. What I'm convinced of is that nobody is ever going to be able to prove which is better, and in the meantime cap-weighted funds are optimum under one set of theoretical assumptions that is no sillier than any other, have "the majesty of simplicity," and are cheap.
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nisiprius
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Re: Cap-weighted funds

Post by nisiprius » Mon Jul 15, 2013 12:12 pm

P.S. This is another situation where I'm faced with such large volumes of such totally conflicting advice that I just shrug and let it go. On the one hand, you have the "small-is-beautiful" crowd, the small-value tilters. Small-cap is 1/10th of the market, but, say, the Bill Schultheis Coffeehouse Portfolio would have you put 1/3 of your stock allocation into small-caps.

And on the other side, you have the blue chip and dividend stock enthusiasts, who want us to invest in great companies that pay dividends and will never let you down because they are, you know, great companies. Don't you even feel disloyal and unpatriotic questioning the future of The Boeing Company? (One might as well question the future of Lockheed or Douglas. Oh, wait...) These enthusiasts have a variety of subflavors, but, predominantly, they like big companies. Let's what style boxes Vanguard "dividend" funds are in: Vanguard Equity Income, Large-Cap Value. Dividend Appreciation Index, Large-Cap Blend. Dividend Growth, Large-Cap Blend. High Dividend Yield Index, Large-Cap Value. Large, large, large, large.

So there's a big coterie that call themselves "Fama-French factor-based investors" who tilt toward small-cap, and another big coterie, who call them "Dividend investors," who tilt toward large-cap. When I'm reading what the first crowd says, it makes a lot of sense. And then when I read what the second crowd says, it makes a lot of sense. But they can't both be right.

As for Apple, it's a good stick to beat cap-weighting with. It's easy to make fun of Apple because the stock was overhyped and tumbled. And because whenever they aren't doing well, we realize once again that they have a goofy name. And because they make pocket-sized iPods instead of jet engines and locomotives. But I don't think a company is icky-poo just because it's big--and I don't think it's my faithful companion who loves me and will never let me down, either.
Last edited by nisiprius on Mon Jul 15, 2013 12:25 pm, edited 1 time in total.
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ogd
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Re: Cap-weighted funds

Post by ogd » Mon Jul 15, 2013 12:24 pm

Cap-weighting has this nice property that it's robust vs mergers and spin-offs. E.g. if Apple decided to split itself into 10 little glittering tech companies, the cap-weighted index would see no change at all. Which is how it should be, given that the underlying business is the same (all other things equal). Equal weighting, for example, would suddenly overweight that business 10x. Cap-weighting of the total stock market is, I think, the only scheme that avoids this problem, e.g. cap-weighted small-cap tilts still have it to some degree.

This makes me comfortable not only that the index can't be gamed, but also that it won't misbehave under pathological scenarios like the whole financial sector deciding to reverse the decades of mergers to abide by size regulations.

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Re: Cap-weighted funds

Post by avalpert » Mon Jul 15, 2013 2:15 pm

boggler wrote:If Apple were 50% of the US Market cap, would it make sense to invest 50% of one's US stock allocation in it? Perhaps not, right?
Why not?

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Re: Cap-weighted funds

Post by Rodc » Mon Jul 15, 2013 4:22 pm

avalpert wrote:
boggler wrote:If Apple were 50% of the US Market cap, would it make sense to invest 50% of one's US stock allocation in it? Perhaps not, right?
Why not?
Don't forget, when Apple hits 50% of the market the P/E will be just over 2345.6, an amazing never before seen the likes of P/E. The creative engine, the amazing never before seen the likes of manager that was required for the amazing never before seen the likes of growth of the company may one day die, and poof, the bubble pops.

If we are going to make up not going to happen examples, we can imagine just about anything. :)
We live a world with knowledge of the future markets has less than one significant figure. And people will still and always demand answers to three significant digits.

boggler
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Re: Cap-weighted funds

Post by boggler » Mon Jul 15, 2013 4:24 pm

Rodc wrote:
avalpert wrote:
boggler wrote:If Apple were 50% of the US Market cap, would it make sense to invest 50% of one's US stock allocation in it? Perhaps not, right?
Why not?
Don't forget, when Apple hits 50% of the market the P/E will be just over 2345.6, an amazing never before seen the likes of P/E. The creative engine, the amazing never before seen the likes of manager that was required for the amazing never before seen the likes of growth of the company may one day die, and poof, the bubble pops.

If we are going to make up not going to happen examples, we can imagine just about anything. :)
Though this is a hypothetical, if it were to happen I'd think it much more likely that whatever large company this is, it would be a diversified holding company similar to Berkshire Hathaway.

avalpert
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Re: Cap-weighted funds

Post by avalpert » Mon Jul 15, 2013 4:28 pm

boggler wrote:
Rodc wrote:
avalpert wrote:
boggler wrote:If Apple were 50% of the US Market cap, would it make sense to invest 50% of one's US stock allocation in it? Perhaps not, right?
Why not?
Don't forget, when Apple hits 50% of the market the P/E will be just over 2345.6, an amazing never before seen the likes of P/E. The creative engine, the amazing never before seen the likes of manager that was required for the amazing never before seen the likes of growth of the company may one day die, and poof, the bubble pops.

If we are going to make up not going to happen examples, we can imagine just about anything. :)
Though this is a hypothetical, if it were to happen I'd think it much more likely that whatever large company this is, it would be a diversified holding company similar to Berkshire Hathaway.
Sure, it would be ticker USA - the Government will have bought up all large companies and put out an IPO as a capital infusion that will allow us to rely less on taxes for operating capital...

boggler
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Re: Cap-weighted funds

Post by boggler » Mon Jul 15, 2013 5:51 pm

ogd wrote:Cap-weighting has this nice property that it's robust vs mergers and spin-offs. E.g. if Apple decided to split itself into 10 little glittering tech companies, the cap-weighted index would see no change at all. Which is how it should be, given that the underlying business is the same (all other things equal). Equal weighting, for example, would suddenly overweight that business 10x. Cap-weighting of the total stock market is, I think, the only scheme that avoids this problem, e.g. cap-weighted small-cap tilts still have it to some degree.

This makes me comfortable not only that the index can't be gamed, but also that it won't misbehave under pathological scenarios like the whole financial sector deciding to reverse the decades of mergers to abide by size regulations.
This argument is really convincing, actually. I think it's pretty important that an investment have the above properties, particularly if you're planning to hold it for a long period of time, where anything can happen.

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momar
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Re: Cap-weighted funds

Post by momar » Mon Jul 15, 2013 5:59 pm

Cap weighting makes sense because you don't know more than the market and the market has already determined the value of every public company based on present and projected future profit. Do you know more than the combined wisdom of every investor?
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Re: Cap-weighted funds

Post by docneil88 » Wed Jul 17, 2013 1:47 am

boggler wrote:If Apple were 50% of the US Market cap, would it make sense to invest 50% of one's US stock allocation in it? Perhaps not, right? If so, why do we invest in a cap-weighted manner in the first place, aside from minimizing transaction costs?
Why do we buy a car, aside from the fact that it gets us where we want to go? Minimizing transaction costs is huge. The ultra-low turnover of cap-weighted funds results in lower costs for commissions, lower management costs (due to zero time spent on deciding whether to buy a stock and the weighting it will have), lower market-impact costs, lower costs resulting from bid asked spreads, and lower capital gains tax costs. Lower transaction costs are pretty much the whole reason that an index fund's return significantly exceeds the aggregate return of all actively invested dollars in the same market.

In addition, cap-weighted funds maximize diversification, and thus lower risk. (As others have argued above, Apple would be far more diversified than it currently is if it were 50% of US market cap.)

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Re: Cap-weighted funds

Post by dumbmoney » Wed Jul 17, 2013 8:07 am

Out of curiosity I checked how Bridgeway Blue Chip 35 Index (BRLIX) is doing, which is an equal weighted large cap fund ("Blue chip investing with a 'buy low, sell high' rebalancing approach", the web site says). Since inception in 1997 it has outperformed the S&P 500, but underperformed the stylistically more similar Dow. The good old Dow, with its antiquated price weighting, beat "buy low, sell high" over the last 16 years. :-)
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