Market cap vs equal weight

talexuser

I have Vanguard FTSE Dev Wor exUK in the ISA as a core and L&G International Index in the unwrapped as the largest (tying with JP Morgan Global Growth Income). Now I'm wondering if the AI trend is becoming a bubble with the big six 30% or more of a market cap index. What are your feelings on equal weight as a backstop if mid size companies have a better chance of growing medium term, or less of a chance of falling if the big boys don't fulfill earnings predictions, and what would your favourite equal trackers be?

aroominyork

Not sure you can equate AI with the tech companies that dominate the S&P. Also, by some value metrics those companies are not overpriced: PSRW is a value-focused smart beta ETF and the top ten holdings include Apple, Microsoft, Amazon, Alphabet and Meta. But there is certainly a case for equal weighting part of your US exposure (not sure I would do it elsewhere) in XDWE or similar funds.

Linton

talexuser said:

I have Vanguard FTSE Dev Wor exUK in the ISA as a core and L&G International Index in the unwrapped as the largest (tying with JP Morgan Global Growth Income). Now I'm wondering if the AI trend is becoming a bubble with the big six 30% or more of a market cap index. What are your feelings on equal weight as a backstop if mid size companies have a better chance of growing medium term, or less of a chance of falling if the big boys don't fulfill earnings predictions, and what would your favourite equal trackers be?

Most of the main players in AI are very large companies for whom AI is a comparatively minor activity. They were already major constituents of world Indexes 5 years ago, pre AI.  Years ago a small company with a good idea could become a large one but now it seems the already large comnpanies have the resurces to buy out any such companies long before they reach the stockmarket.

The one exception I would be wary of is NVIDIA which were known as a major supplier of graphics processors for computer gaming hardware.  Highly successful in their niche but not in the same league as Apple, Microsoft etc.  Since this hardware was unrivalled for the large scale computation required for AI they seem to have acquired a monopoly in that area.  So their base is nothng like as strong as the other leading AI companies and it would not be impossible for someone else to develop competitive hardware.

But surely as a passive-based investor you should not be doubting the valuations given by the markets.

I do not believe equal weighted trackers are the answer as they appear to be going too far. A share  in your local corner shop is not the equivalent of a share in Apple even though both could be giving the same % profits.  I tackle the tech bubble risk by tracking the % sector allocations and rebalance should they change by a significant amount. But I am not a striong believer in passive investing.

talexuser

Thanks, the question was because of a Trustnet article today which argued the first post basically. The trackers are just 20% of each portfolio and I am mainly active too - like to think you can pick some winners .

I can't see we are in any boom times for the short term, maybe even medium, and the markets will be in a sideways direction with noise up or down barring some black swan catastrophe. Actives might be difficult to outperform, maybe slow and steady for these times.

GeoffTF

Equal weight is effectively a speculation that smaller companies will do better than larger companies. If too many people invest that way, the shares of smaller companies become overpriced and underperform subsequently. Unless you know more than the market, you are best to stick to market weight.

Linton

GeoffTF said:

Equal weight is effectively a speculation that smaller companies will do better than larger companies. If too many people invest that way, the shares of smaller companies become overpriced and underperform subsequently. Unless you know more than the market, you are best to stick to market weight.

I think this argument is faulty in that market caps can be higher simply because a company has more shares issued rather than because the market preferentially values its shares.

Let's take a simple example.  Say in a given market there are two companies.  In all fundamental respects except size the companies are identical. One company, A, has earnings of £100M with 100M shares each priced at £10.    Another company, B,  earnings of £1B with 1B shares again each priced at £10.  Each share represents the same value of underlying assets and the same earnings.  In pricing the shares identically the market  regards both companies as having the same future prospects and does not expect either will grow at the expense of the other. 

An index investor would put 90% of their money in company B and 10% in company A.  But the market is actually saying that the two investments are identical, not that it expects Company B to out-perform company A.  Surely a rational investor seeking to maximise diversification would put 50% of their money in each company rather than speculating that the larger company will perform better.

wmb194

talexuser said:

I have Vanguard FTSE Dev Wor exUK in the ISA as a core and L&G International Index in the unwrapped as the largest (tying with JP Morgan Global Growth Income). Now I'm wondering if the AI trend is becoming a bubble with the big six 30% or more of a market cap index. What are your feelings on equal weight as a backstop if mid size companies have a better chance of growing medium term, or less of a chance of falling if the big boys don't fulfill earnings predictions, and what would your favourite equal trackers be?

The other day David Stevenson, a finance writer, mentioned this in a post of his. He says that academics generally agree that equal weight is the way to go but you'll have a hard time finding equal weight ETFs as they are more expensive to run and so few providers want to offer them.

"...you end up with companies with a smaller value having more influence over the final index returns i.e it’s an anti-concentration strategy.

On paper equal weight indices tend to win every theoretical backtest. But in reality, ETF issuers are reluctant to embrace EW indices because of that cost issue ... and also because volatility is usually higher."

https://davidstevenson.substack.com/p/investment-ideas-money-market-plus

coastline

Domination by a few stocks isn't something new looking at the 100 year history of US .

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Top 5 in FTSE is well over 30% and other world indices aren't that far behind.

iShares plc Share Price (ISF) Core FTSE 100 UCITS ETF (Dist) | ISF (hl.co.uk)

Value Line Index versus SP500. Sometimes it's better to go with the flow ?

Value Line Composite Index Definition (investopedia.com)

Value Line Geometric Index, VALUG Advanced Chart - (1083) VALUG, Value Line Geometric Index Stock Price - BigCharts.com (marketwatch.com)

Value Line Geometric Index, VALUG Advanced Chart - (1083) VALUG, Value Line Geometric Index Stock Price - BigCharts.com (marketwatch.com)

It's not at the levels of the dotcom era..

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100 years of Large v Small.

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From a weekly updated site. Growth v Value 

Growth vs Value (yardeni.com)

World forward P/E's

MSCI Forward P/Es (yardeni.com)

EthicsGradient

Linton said:

GeoffTF said:

Equal weight is effectively a speculation that smaller companies will do better than larger companies. If too many people invest that way, the shares of smaller companies become overpriced and underperform subsequently. Unless you know more than the market, you are best to stick to market weight.

I think this argument is faulty in that market caps can be higher simply because a company has more shares issued rather than because the market preferentially values its shares.

Let's take a simple example.  Say in a given market there are two companies.  In all fundamental respects except size the companies are identical. One company, A, has earnings of £100M with 100M shares each priced at £10.    Another company, B,  earnings of £1B with 1B shares again each priced at £10.  Each share represents the same value of underlying assets and the same earnings.  In pricing the shares identically the market  regards both companies as having the same future prospects and does not expect either will grow at the expense of the other. 

An index investor would put 90% of their money in company B and 10% in company A.  But the market is actually saying that the two investments are identical, not that it expects Company B to out-perform company A.  Surely a rational investor seeking to maximise diversification would put 50% of their money in each company rather than speculating that the larger company will perform better.

Each individual £10 share may represent the same value of underlying assets and earnings, but that doesn't mean the market sees the companies as having the same prospects, or whether they grow at the other's expense. The market is not, however, saying they are "identical"; company A has 10 times the capacity to produce goods and services, and thus can be said to be worth 10 times the investment. If company A were to split into 10 daughter companies, an equal-weight investor would have to invest 9 times the amount they had in it before, just to keep the balance. Economies of scale and use of monopoly tactics say that, if anything, the larger company has better prospects.

Using market capitalisation weighting is not speculating that a £10 share of the larger company will perform better; it's speculating that the 10-times-bigger company will keep its market share, and earn 10 times the future profit, overall, of the smaller one.

If your purpose is just to maximise diversity, rather than take part in the overall growth of an economy, then yes, by all means, just buy a few different companies.

Linton

EthicsGradient said:

Linton said:

GeoffTF said:

Equal weight is effectively a speculation that smaller companies will do better than larger companies. If too many people invest that way, the shares of smaller companies become overpriced and underperform subsequently. Unless you know more than the market, you are best to stick to market weight.

I think this argument is faulty in that market caps can be higher simply because a company has more shares issued rather than because the market preferentially values its shares.

Let's take a simple example.  Say in a given market there are two companies.  In all fundamental respects except size the companies are identical. One company, A, has earnings of £100M with 100M shares each priced at £10.    Another company, B,  earnings of £1B with 1B shares again each priced at £10.  Each share represents the same value of underlying assets and the same earnings.  In pricing the shares identically the market  regards both companies as having the same future prospects and does not expect either will grow at the expense of the other. 

An index investor would put 90% of their money in company B and 10% in company A.  But the market is actually saying that the two investments are identical, not that it expects Company B to out-perform company A.  Surely a rational investor seeking to maximise diversification would put 50% of their money in each company rather than speculating that the larger company will perform better.

Each individual £10 share may represent the same value of underlying assets and earnings, but that doesn't mean the market sees the companies as having the same prospects, or whether they grow at the other's expense. The market is not, however, saying they are "identical"; company A has 10 times the capacity to produce goods and services, and thus can be said to be worth 10 times the investment. If company A were to split into 10 daughter companies, an equal-weight investor would have to invest 9 times the amount they had in it before, just to keep the balance. Economies of scale and use of monopoly tactics say that, if anything, the larger company has better prospects.

Using market capitalisation weighting is not speculating that a £10 share of the larger company will perform better; it's speculating that the 10-times-bigger company will keep its market share, and earn 10 times the future profit, overall, of the smaller one.

If your purpose is just to maximise diversity, rather than take part in the overall growth of an economy, then yes, by all means, just buy a few different companies.

I agree that equal weight investing is flawed for the reason you give.  I am pointing out that "market cap wighting enables individual investors to optimally follow the market's assessment of a company" argument for market cap weighting is also flawed.   Company B will have 10X greater returns and 10X the resources for investment but the benefits of those is split amongst 10X  the number of investors.

As regards benefits of scale etc the larger company may have: it follows from the Efficient Market Hypothesis that any benefits that the larger company may have are already priced in and therefore will be balanced by an extra cost of their shares compared with those of the smaller company.  This does not affect the logic of my argument but merely makes it more complex to explain.

The primary benefit of Market Cap weighting is that it is cheaper for funds to implement since it minimises the number of transactions.  However it has the downside of reduced diversity and flexibility compared with other strategies.  So like most other options in investing it comes down to your objectives and priorities.

JohnWinder

You can look at the historical returns of equal weighting at portfoliovisualizer. My sense is that it hasn’t been that much different from cap weighting, perhaps helped a bit by having more small cap which might be higher risk with higher return. My sense also is that it doesn’t fare so well in bad times, or the recent 6 years because of the big tech stocks; if so, be dedicated to it so you ride out the underperforming years. 

Then there are the ‘frictional’ losses from fund management: rebalancing; buy/sell spreads; taxes.

However logical equal weighting might be, you’ll never really do it because the very small cap companies don’t have enough stock; a company with a value of only $1M, half of which is in tightly held hands, means on $500K is available for all index funds. Even if yours is the only index fund, it means you can hold only $500k of Apple. Sounds crazy but it might work, although the fund managers of iShares big equal weighted USA fund choose on 650 stocks for their fund. There’s a lot more stocks in the US market they are leaving out of equal weighting.

There are always academics looking for a new discovery, index providers a new product, or fund managers looking for a new edge to attract investors; sometimes they’re helpful to we miserable investors, sometimes not.

‘100M shares each priced at £10.    Another company, B,  earnings of £1B with 1B shares again each priced at £10.  Each share represents the same value of underlying assets and the same earnings.  In pricing the shares identically the market  regards both companies as having the same future prospects‘

Perhaps the fallacy of this argument is that cap weighting is done on the basis of company value, not share value.

‘Surely a rational investor seeking to maximise diversification would put 50% of their money in each company rather than speculating that the larger company will perform better.’

They might if that’s how they defined diversification. But the market, with the wisdom of all its participants has decided one is worth 10x the other; individuals can have other views. But history is what it is, and can be seen on portfoliovisualizer.