One-sided discussion follows. In my personal opinion, attacks on market cap weighting are often amplified by the self-interest of those making the attacks. Not only does Vanguard have the lion's share of basic cap-weighted total market mutual funds, but, thanks to Vanguard's competition, there isn't a lot of money to be made in cap-weighted total market index funds by anyone. You gotta have a gimmick, and claims that departures from market cap weighting are superior to market cap weighting are a good gimmick.
John C. Bogle pointed out in
Common Sense on Mutual Funds that all of the early editions of Jeremy Siegel's
Stocks for the Long Run said that cap-weighting was optimal. He then changed--at the same time that became a participant a firm, WisdomTree, that sold mutual funds based on a non-cap-weighted "fundamental index" developed by Siegel.
The pros of market cap weighting all stem from the fact that it mirrors the actual composition of the market. The market itself is cap-weighted. There's just no way around that. Under a set of assumptions that are neither fully realistic nor utterly crazy, according to financial economics theory this makes it mean-variance optimum, but to me there are other convincing arguments in favor of it.
The big one for me is that cap-weighting
cancels out the effect of speculative trading on my portfolio. A cap-weighted portfolio passively participates in the growth of the stock values of growing companies. Every other weighting implies partial participation in speculation. Every other weighting means you are taking sides, you believe that your weighting is reflects a shrewder valuation of stocks than those of other participants, and that in addition to profiting from the growth of the market, you are going to get an additional return
by taking money away from other investors. If you are wrong, of course, they are going to take money away from you. Many of the arguments by fundamental indexing, factor strategists, and "smart beta" proponents acknowledge this, and state reasons as to why their strategies can continue to take money away from other investors even after other investors know that they are doing it, and know how they are doing it; I find it hard to judge the plausibility of those reasons; you must judge for yourself.
Another point is that cap-weighted portfolios are self-rebalancing. In theory, once you are cap-weighted, there is no need to buy or sell any stocks to maintain cap-weighting. Thus, transaction costs are low. This is a point that's surprisingly hard for people to grasp, and it is often intentionally misrepresented by people attacking cap-weighting. For example, suppose Facebook were to double in price and become 2.8% of the market instead of 1.4%. People often suggest that index funds would need to run out and buy more of this now-possibly-overprice stock. That's nonsense. They would need to do nothing of the sort. Simply by holding their shares, making no purchases or sales, the price of the shares they already hold would double, and the dollar weight in their portfolio would double from 1.4% to 2.8% simply because of that. (The funds that
would need to run out and buy more would be factor funds with commitments to the "momentum" factor).
Another point is that cap-weighted total market investing is the only strategy that cannot become overgrazed. In a thought experiment, small-cap value is only 2% of the market so it is not possible for everyone to have 20% of their portfolio in small-cap value. If everyone tried, eventually the supply of small-cap value stocks would dry up and scarcity would boost their price. Cap-weighted investors remove all stocks from the market proportionally, and even in theory their activity does not change the relative plenty or scarcity of the stocks in the market.
The arguments against cap-weighting take advantage of the fact that many investors aren't clear on what the dollar-weighted composition of the stock market looks like. They can be easily surprised when someone says that the ten largest stocks account for 20% of the market, or that the thirty stocks in the Dow Jones Industrial Average account for $7 trillion / $32 trillion = 22% of the market. They then claim that this represents a "concentration" in large caps, which is like saying that seawater has a huge "concentration" of water, or that we are breathing air that is "concentrated" in nitrogen.
It is perfectly true that a cap-weighted total market index fund (blue) is going to behave similarly to an S&P 500 index fund (orange), which in turn is going to behave similarly to a Dow Jones Industrial Average ETF (green). The market is the market. The total value of the market is determined by where the money in it is is, and investors put most of their money in the largest stocks. Morningstar classifies total market index funds as "large-cap blend," and should. The market mostly
is large-caps, so large caps act like the market and the market acts like large-caps. You can say that in a sneering tone of voice and say "isn't that
awful," but that doesn't necessarily make it awful. Indeed, for every guru who says you ought to overweight small-cap value, there is another one touting large-cap growth (usually in the form of an active fund)... and there are a lot of investors who want a portfolio of
exclusively "blue chips."
Source
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.