Market cap vs equal weight

MK62

JohnWinder said:

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

I was under the impression that most indices used the free float market cap method of valuing companies......which makes a company's market cap directly related to it's share price as quoted in the index.

JohnWinder

Sorry for my sloppy writing. I think I agree with you, but as you've expressed it does it make it any clearer? Your 'company's market cap' is indeed directly related to share price, yes, but we need share number as well to give us company value. I think.

GeoffTF

The entire market could put all of its money in a single market weighted tracker fund. The money invested in each company and their share prices would not change as a result of that.

Imagine what would happen if the entire market tried to put all its money into an equal weighted tracker fund. The fund would invest the same amount of money in Apple and the little newsagents at the end of my road. Apple would become ludicrously undervalued, and the newsagent would become ludicrously overvalued. The owner would not sell for anything less than the tracker had to pay.

As I said, if too many people buy equal weighted trackers the smaller companies will become over valued relative to the larger ones.

Linton

GeoffTF said:

The entire market could put all of its money in a single market weighted tracker fund. The money invested in each company and their share prices would not change as a result of that.

Imagine what would happen if the entire market tried to put all its money into an equal weighted tracker fund. The fund would invest the same amount of money in Apple and the little newsagents at the end of my road. Apple would become ludicrously undervalued, and the newsagent would become ludicrously overvalued. The owner would not sell for anything less than the tracker had to pay.

As I said, if too many people buy equal weighted trackers the smaller companies will become over valued relative to the larger ones.

In this hypothetical ultimate situation when all shares are owned by cap weighted tracker funds and the price discovery mechanism ceases to operate surely the value of any share would solely lie in its guaranteed position in the index.  Factors like profitability and growth would be totally irrelevent since no-one would be using them as a basis for trading.  

But you have got to get to that point.  Once the tracker funds began to distort the market away from fundamentals leading to seriously undervalued and over valued shares there would be opportunities for active funds to make large returns from areas like undervalued  dividend paying companies.  The high yields from such funds would attract customers who previously invested in trackers.

Similarly  if total market, equal weight trackers began to cause small companies' shares to rise too far the resultant poor performance of those trackers would lead to their investors looking elsewhere.

The conclusion appears to be that the ultimate scenario of allshares  being owned by trackers is unstable and hence could never happen.  We could not even get close to it.

Have faith in the markets - over the long term they keep prices tied into reality.

GeoffTF

Linton said:

GeoffTF said:

The entire market could put all of its money in a single market weighted tracker fund. The money invested in each company and their share prices would not change as a result of that.

Imagine what would happen if the entire market tried to put all its money into an equal weighted tracker fund. The fund would invest the same amount of money in Apple and the little newsagents at the end of my road. Apple would become ludicrously undervalued, and the newsagent would become ludicrously overvalued. The owner would not sell for anything less than the tracker had to pay.

As I said, if too many people buy equal weighted trackers the smaller companies will become over valued relative to the larger ones.

In this hypothetical ultimate situation when all shares are owned by cap weighted tracker funds and the price discovery mechanism ceases to operate surely the value of any share would solely lie in its guaranteed position in the index.  Factors like profitability and growth would be totally irrelevent since no-one would be using them as a basis for trading.

If most of the market is invested in a market weighted trackers price discovery would continue provided that a small number of active investors remained.

If most of the market invested in an equal weighted tracker, the price of the smallest stocks would be forced up. My newsagent will sell at to the tracker at a bonkers high price irrespective of what the active traders thought, and the tracker would not be allowed to sell. The investors in the equal weighted would eventually realise their folly, and sell up at a loss.

MK62

Its all hypothetical though......the whole market will not invest  solely in equal weighted trackers....or market cap weighted trackers......or active funds/ITs.......or individual shares......

I think the jury is out tbh........if you look at the S&P500, the 80:20 principle seems to be in effect....where 80% of all the returns have in recent times been generated by the top 20% of that index (ie the top 100)......market cap weighting would have put about 67% of your investment there........equal weighting would only have put 20% there.......though it's more complex than that in reality, ofcourse.