Which Index funds to invest in?

Linton

GeoffTF said:

Cus said:

Deciding to invest based on market caps is to me an active decision similar to  deciding to invest based on other values, such as valuations, earnings, whatever.  I've no issues with that.  My concern is the perceived belief, based on a number of internet investment movements over many years, that investing in market cap based weightings is the default goto and will deliver the best long term results, and that an individual should not engage their own research as how can they beat a market.

If you buy a market weighted tracker, you buy the performance of the average dollar invested in the market (before costs). You also have very low costs. Additional costs compound up over time. After a market weighted tracker has been held for many years, it will have beaten nearly all the actively managed alternatives.

Consider a fund weights according to earnings rather than market cap (the most plausible of your alternatives). That is active investment by definition because it overweights companies with higher earnings and underweights those with lower earnings. If you bought such a fund, you would in effect saying that earnings are a better indication of a company’s value than its market weight. (Think about what would happen if a large proportion of the market - or all the market - bought that fund.)

Market weighted trackers do not trade, except when companies enter or leave the market, or in response to corporate actions. (If the stock price doubles, the market weight doubles too.) That keeps costs to a minimum and ensures that holding the fund does not affect market prices. A fund that weights according to earnings has to constantly rebalance.

Surely any particular market should ensure that all frequently traded stocks are priced according to the market's perception of their future returns. The price of a stock that was considered of lower than average value would soon fall and one considered of better than average value would increase (Efficient Market Hypothesis). 

In that case one should be free to choose any frequently traded stocks according to your own criteria without impacting expected future returns.  I agree that lower costs for cap weighted funds is a factor but it may not be the over-riding one.

The issue becomes more difficult across multiple markets where it is less clear that the EMH applies as many investors do not have the ability or the wish to trade in different markets in different currencies across the world.

GeoffTF

Linton said:

GeoffTF said:

Cus said:

Deciding to invest based on market caps is to me an active decision similar to  deciding to invest based on other values, such as valuations, earnings, whatever.  I've no issues with that.  My concern is the perceived belief, based on a number of internet investment movements over many years, that investing in market cap based weightings is the default goto and will deliver the best long term results, and that an individual should not engage their own research as how can they beat a market.

If you buy a market weighted tracker, you buy the performance of the average dollar invested in the market (before costs). You also have very low costs. Additional costs compound up over time. After a market weighted tracker has been held for many years, it will have beaten nearly all the actively managed alternatives.

Consider a fund weights according to earnings rather than market cap (the most plausible of your alternatives). That is active investment by definition because it overweights companies with higher earnings and underweights those with lower earnings. If you bought such a fund, you would in effect saying that earnings are a better indication of a company’s value than its market weight. (Think about what would happen if a large proportion of the market - or all the market - bought that fund.)

Market weighted trackers do not trade, except when companies enter or leave the market, or in response to corporate actions. (If the stock price doubles, the market weight doubles too.) That keeps costs to a minimum and ensures that holding the fund does not affect market prices. A fund that weights according to earnings has to constantly rebalance.

Surely any particular market should ensure that all frequently traded stocks are priced according to the market's perception of their future returns. The price of a stock that was considered of lower than average value would soon fall and one considered of better than average value would increase (Efficient Market Hypothesis).

I think you misunderstood what I was trying to say in the sentence that you have emboldened. If you add together every investor's portfolio, you have all the stocks in the market. The market as a whole clearly tracks the market weighted index. If you divide the market capitalisation of the market at time t by the market capitalisation a time t0, you have the performance of the average dollar in the market. In percentage terms that is exactly the performance of the market as a whole. It is also the performance of a completely cost free market weighted tracker. Sorry if I was not clear.

GeoffTF

Linton said:

In that case one should be free to choose any frequently traded stocks according to your own criteria without impacting expected future returns.  I agree that lower costs for cap weighted funds is a factor but it may not be the over-riding one.

You could say that if the market was completely efficient, any cost free portfolio should have the same expected return as the market. Nonetheless, that return could be a lot different to the market, and it could be a lot less. There would be no expectation that you would match the average investment in the market (before costs). There would also be no expectation that you will beat most active investors over time (after costs). With a market weighted tracker, you have that expectation, irrespective of whether the market is completely efficient. Active investing is zero sum game with respect to the market. Every dollar of out-performance is matched by another dollar of under-performance. It may not be glamorous to be average and cheap, but it works.