Passive funds that cap the top holdings?

Mr.Saver

If such fund exists, and it starts with say 1% cap, and it owns only 1% of Microsoft shares. But what if Microsoft share price then goes up, and other shares didn't change? Would the fund have to sell some Microsoft shares and buy other shares? And the second day, Microsoft share price goes down to where it was before, will this fund then sell other shares and buy more Microsoft to keep it at 1%? This will increase transaction costs which eats into your returns, not a wise thing to do.

Aretnap

Mr.Saver wrote: »

If such fund exists, and it starts with say 1% cap, and it owns only 1% of Microsoft shares. But what if Microsoft share price then goes up, and other shares didn't change? Would the fund have to sell some Microsoft shares and buy other shares? And the second day, Microsoft share price goes down to where it was before, will this fund then sell other shares and buy more Microsoft to keep it at 1%? This will increase transaction costs which eats into your returns, not a wise thing to do.

Equal weight funds generally generally carry out their rebalancing at medium-sized intervals (eg quarterly) in order to keep trading costs reasonable. There's obviously a compromise that can be stuck between trading costs and attempting to keep the weighting exactly equal at all times. There's no reason why a capped index fund could not do something similar.

For the UK market at least capped index funds do exist. Here is one which follows the FTSE all share index but caps its weightings so that no company makes up more than 5% of the fund.

https://fundcentres.lgim.com/uk/workplace-employee/fund-centre/UK-Equity-5-Capped-Passive-Fund?isin_code=BC03

Only catch is that currently the only company that makes up more than 5% of the FTSE is HSBC, and they only account for slightly more than 5%. So the fund is in practice just a FTSE tracker with a rounding error in its HSBC allocation.

bowlhead99

Aretnap wrote: »

For the UK market at least capped index funds do exist. Here is one which follows the FTSE all share index but caps its weightings so that no company makes up more than 5% of the fund.

https://fundcentres.lgim.com/uk/workplace-employee/fund-centre/UK-Equity-5-Capped-Passive-Fund?isin_code=BC03

Only catch is that currently the only company that makes up more than 5% of the FTSE is HSBC, and they only account for slightly more than 5%. So the fund is in practice just a FTSE tracker with a rounding error in its HSBC allocation.

Within the official FTSE all-share index the largest company is usually Royal Dutch Shell, whose class A and class B shares together are worth the best part of £200bn and would make ~8% of the index, even though individually the two stocks are worth less than 5% each. #

In the top 10 holdings of that LG pension fund I see they only hold the B shares, and not at full weight; though they do say that the holdings may diverge from the index for efficiency. But it's almost as if they have capped RDS in total to 5% but are then only holding one of the share classes, restricting the total weight much more. Perhaps it is simply a data feed issue and they do actually hold both classes of RDS share for approx 5% total but are misreporting one.

Capped cap-weighted indexes are not popular and the linked example is not available as a mainstream OEIC to buy on all platforms. It is just a small pension fund product. FTSE Russell do publish capped indexes for a number of markets but generally that's for regions with a small number of dominant companies, particularly in the less developed markets - such as Russia, India ; or in places like Switzerland, HK or Korea.

Aretnap wrote: »

Equal weight funds generally generally carry out their rebalancing at medium-sized intervals (eg quarterly) in order to keep trading costs reasonable. There's obviously a compromise that can be stuck between trading costs and attempting to keep the weighting exactly equal at all times.

I have an equal-weighted midcap fund (iShares MSCI World Size Factor UCITS ETF) to give me some general mid-cap exposure; it rebalances every 6 months between about 900 holdings. The return will be quite different to just capping one or two of the bigger holdings, but any sort of rebalancing is inherently more expensive than cap-weighting.

Malthusian

The major issue with equal-weighted trackers is that if you buy an equally-weighted FTSE 100 tracker, you are saying that you want 1% of your money in the 100th biggest company (and the 99th and 98th) but nothing in the 101st and 102nd.

Alternatively, if you look for an equally-weighted All Share tracker (not sure if they exist), you are saying you want an equal amount in Industrial Heat, International Oil and Gas and similar spiv toilet paper as HSBC.

Alternatively alternatively, if you say that you want an equally-weighted All Share tracker with a cut-off to exclude the really obscure and illiquid end of the market, this is the exact same issue as the FTSE 100 equally weighted tracker.

If you are going to take active management decisions you should at least try to take ones that have some kind of logic behind them. There is no logic behind investing 1% of your money in the 100th biggest company in the UK stockmarket but 0% in the 101st. There is a logic behind passively investing your money in proportion to the companies' relative importance as determined by the market consensus.

Equally weighted trackers exist to satisfy demand from investors who are applying the Politician's Syllogism and haven't thought it through. The Politician's Syllogism is "Something must be done, this is something, therefore I must do this." (Logically equivalent to "My dog has four legs, my cat has four legs, therefore my dog is a cat".) "I want to allocate money to the FTSE but don't want to have 7% of my money in HSBC, an equally weighted tracker wouldn't have 7% in HSBC, therefore I should invest in an equally weighted tracker."

If you are invested in a diversified global portfolio, the biggest company in the entire world could go bankrupt, a major scandal that would occupy the newspapers for weeks, and the courts for years. A scandal that would make Enron look like London Capital & Finance and London Capital & Finance look like "Plymouth accountant convicted by magistrates for £350,000 fraud". And a few years later it would have had no discernible effect on the portfolio. The disappearance of 2% of your money would have been lost in the noise, the market would have bounced back from any contagion panic, and the earnings of the disappeared company would have been reallocated to other companies in your portfolio.

Tom99

Not quite the same thing but for my UK shares I hold an equal amount of FTSE100 and FTSE250. That means 3.5% in HSBC rather than 7%.
I think even a FTSE all share would only reduce the HSBC holding to about 5.4%.

MK62

That major issue could just as easily turn out to be it's major advantage....

The bottom line is that there is no way to know today, whether a market-cap weighted index tracker fund would perform better or worse than an equal weighted version, going forward, over an unknown length of time.

The Invesco S&P500 Equal weighted ETF has outperformed over a period in excess of 10 years, but has consistently underperformed over shorter periods.......which leads to the conclusion that either could be better under the right market conditions, and since those conditions in the future are unknown............

eskbanker

Tom99 wrote: »

Not quite the same thing but for my UK shares I hold an equal amount of FTSE100 and FTSE250. That means 3.5% in HSBC rather than 7%.
I think even a FTSE all share would only reduce the HSBC holding to about 5.4%.

Wasn't it you who has a massively UK-dominated (90+%) equity portfolio?

If so, you're making a conscious decision to have the likes of HSBC dominating your holdings instead of FAANGs, which just seems like fire instead of frying pan to me....

Edit: this is the thread I was thinking of: https://forums.moneysavingexpert.com/discussion/5881276/easy-two-fund-portfolio

IanSt

bowlhead99 wrote: »

I have an equal-weighted midcap fund (iShares MSCI World Size Factor UCITS ETF) to give me some general mid-cap exposure; it rebalances every 6 months between about 900 holdings. The return will be quite different to just capping one or two of the bigger holdings, but any sort of rebalancing is inherently more expensive than cap-weighting.

Hmmm, interesting, so that means it's tilted towards the smaller companies in there. Do you know off the top of your head how much bigger the biggest companies would be held at if they were held in their natural percentages, does it actually make much difference?

Linton

There is one tracker which incorporates holding caps. The Vanguard FTSE UK Equity Income Index (FUEI) fund follows, not surprisingly, the FTSE UK Equity Income Index. You may never have heard of this index as it's one I believe Vanguard commissioned FTSE to provide and does not seem to be publicly available. This would explain which why no other company offers competing trackers.


The catastrophic performance of IUKD during the Great Crash, from which it has barely recovered even with reinvested dividends, showed that passive dividend funds could not safely be based on yield alone - the banks were major dividend payers. So the FUEI itself incorporates limits on sector and individual holdings. To me that is stretching the concept of an index to or beyond its limits. However I guess calling the fund an index tracker is good for sales.

bowlhead99

IanSt wrote: »

Hmmm, interesting, so that means it's tilted towards the smaller companies in there.

Yes, the 'size factor' is a play on the fact that smaller companies have historically been correlated with greater returns and so if standard cap weighting skews your money towards less-small companies, equal weighting will position you back to a mix of company sizes.

Do you know off the top of your head how much bigger the biggest companies would be held at if they were held in their natural percentages, does it actually make much difference?

The largest in MSCI world midcap (though it can change) would currently be something like London Stock Exchange plc which as of a couple of months ago (I don't have a live feed) had got up to about 0.4% of the index - it's currently a £24bn company. That would be around 20x the smallest; the £1-1.5bn companies would only usually take about 0.02% of the index on a cap weighted basis.

In the equal weighted index they would all start at the same weight (about 0.11%) and then over time before the next rebalance you would have seen LSE go up to more like 0.14-0.15% due to the strong share price rises driven by their M&A activity before later being reset to 0.11% again (if it still qualified for inclusion).

To be honest in the midcap range the size disparity is not so extreme as it can be with an all-share type of index - e.g. even going from a £4bn 'bottom of the FTSE100' company to Apple at £1000bn is a 200x difference in weight.

My use of the midcap ew fund is really just to get broad exposure to mid size companies around the world from all sorts of industries that produce companies of that size. Getting mega caps is easy because they feature heavily in cheap trackers and in lots of big name active funds and the various industry/thematic funds that people might use.