Flaws of Market Capitalization Indexes

 |  Includes: AGG, SPY
by: Manshu Verma

Market Capitalization Weighted

Since the beginning of modern portfolio theory that started back in the 1950s and 1960s, one of the main premises was that “markets were efficient.” By market, the academic meant a market weight capitalization index. In theory, a market weight capitalization index was easy to construct, since the only variable was market cap. In fact, till this day, this has become the most common way indexes are calculated.

Having said that, there are flaws in this methodology. The main flaw is that as market rise, the index tends to get more expensive. That is because to maintain its market weight, large cap stocks are bought more, hence driving up prices and valuation. But the opposite also happens when the market tanks. As market cap declines, more selling begets more selling.

The phenomenon is most pronounced when a new stock is included in the index and another stock drops out. The stock which is included would have seen a price run up and vice versa for the stock dropping off.

This is where the danger is for folks who have a regular monthly investment program in an index like the S&P 500 Spider ETF (NYSEARCA:SPY). In a rising market, you are constantly buying a more expensive index. To combat this flaw, some indexes are now not based on market cap but instead on some other fundamental factors like dividend yield, or instead they are based on revenue or some combination of factors that are not just related to market cap. The RAFI index and ETF is one example of such an index. Though historical data points to outperformance of the RAFI index versus the S&P 500, it will be interesting to see how it does going forward.

Market Capitalization and Debt Indexes

If you are not so hung up over the flaws of the S&P, I think there is more concern about debt indexes – and in particular the debt government index.

There is nothing wrong with a company achieving large cap status (in fact, that should be the goal). But the goal of any company should be to have less debt and not more. When General Motors and Ford (NYSE:F) and their respective finance companies fell into junk status, they became the largest debt issuers in the high yield index by a significant amount. In fact, high yield managers’ outperformance or underperformance versus the index really depends on their views and weightings in their portfolio relative to Ford Motor Credit or GMAC!

But right now we could have an even more severe problem. Since the government debt of developed nations is spiraling out of control, there is a real issue and danger in the sovereign bond index. After all, beyond a certain point, having too much debt will eventually become a fiscal and solvency issue.

So, if the United States has a very large weighting in a sovereign index because of its sheer size, does it mean we as investors should also have the weightings in our bond portfolio. Well, I would say that when debt was a manageable issue, that would not have been a problem. But now, it could be a potential issue. Perhaps weighting your bond portfolio based on criteria like debt to GDP ratio and other factors will be more sensible.

Ending Thoughts

I started off this post with a look at the flaws of a traditional market cap based index. This issue becomes a problem for investors of a stock market index during a bull market. But I fear that government bond indexes are increasingly becoming an important issue going forward. If you have a substantial portion of your savings in G7 government bonds, I would seriously do more investigation and research into it.

I think doing more thorough research and using individual country of market cap specific or industry type ETFs would not be such a bad idea going forward.

Disclosure: No positions