Alternatives to cap-based weighting in index funds

I just stumbled over this article about whether cap-weighed index funds may not be the ideal solutions.

https://www.msn.com/en-us/money/savingandinvesting/the-fundamental-flaw-in-cap-weighted-index-funds/ar-BB1cywrh

From other sides I heard that indeed the market capitalisation of some companies could actually be in some sort of bubble as index funds just blindly pump them further.

My question to all you experts:

  • What do you think of this article. Is this just fear mongering or do you agree?
  • Are there some useful non-cap-weighted index funds you are aware of? And if yes, should they be a part of a mustachian portfolio?

I’m really curious as of what you think about that…

There were already some threads like that…

Reality for me would be :

  1. I cannot predict if it is right or not, I cannot predict the future
  2. I am not able to determine when a most certain correction will occur (it will occur, I do not know when)
  3. Through index funds, I am owning companies, these companies are generating revenue. So I will be better off investing than just doing nothing. I might overpay them right now, during a correction (or for instance during the pandemic, I got them cheap.

BTW dividends where rather stable the last y compared to the previous one…

The index funds strategy (for private) has one goal : generate a quasi certain revenue over the long term at a minimum of cost, be it TER and time. I am expecting 5 +x% after inflation and tax, that is fine for me and ensure that I won’t die poor. The rest is irrelavant.

My 2 cents.

If you speak German, I can recommend you the “egal” series from the Finanzwesir. If your investment goal differs, the relevancy of it differs.
Das Ziel: Nicht arm sterben! - YouTube

EDIT: Link edited for more relevancy

S&P500 is a bad index fund because only large caps are selected. It could even be considered as an active fund due to a committee choosing which stock is in the S&P500. To avoid the issue a total stock index is better.

I completely agree. My point is not about doing (2) market timing or (3) not owning companies.

My only point is to discuss the arguments in the article. Namely that creating an index fund using the “market-cap” criteria may not be optimal and whether there are alternatives approaches that allow passive and low-cost investing but with another weighting.

There are other approaches. GDP approach etc.

Question is :
Nestle is participating in the GDP nearly all countries in the world. Where would you put it ?
And now you have to redo it with every international company.

In the end : nothing beats the market cap one or two ETF in terms of cost ratio/return.

And btw, there is a large chunk of the world economy which is not included in the ETFs. Just take all the companies which are actually not listed on the stock market, and actually there are some big ones (Dell for instance, which unlisted some time ago) or some other where there is no free floating capital

Does not matter really…
The difference over the VTI and the VOO is abou 0.0x% over 10y

Some go even as far to represent whole northamerica by VOO. Mexico is a developing country and Canada is 5%. Does not matter much.

old post but a great subject

i guess if you deviate from market-cap weighting (leaving aside the varying restrictions to certain countries of world indices), it’s due to a) risk mgmt / diversification purposes (and insurance always comes with its own set of some ‘risk’, in this case potential costs due to potential underperformance) and/or b) an active decision to hopefully outperform. i guess your approach at minimum leads to good risk-adjusted returns.

also, the level of globalisation as well as domestic growth probably are important aspects. let’s say the usa companies have a 50/50 share of domestic vs. foreign revenues/profits. let’s also assume next 20 yrs there’s a deglobalisation trend but the country’s population continues to grow, that’d lead to a negative and a positive trend for u.s. co’s.

in the end, most important is risk awareness, no matter the individual decision that follows.

but isn’t ‘winners are going to stay winners’ basically inherent to darwinism/capitalism and also market-cap based as well as quality based investing?

Any deviation from global market cap portfolio is a concentration, not a diversification.

but only compared to the specific index/definition

It’s true to a degree. Fundsmith, for instance, would subscribe to that notion. That said, companies and whole industries have lost relative to their former market cap. Stock indices aren’t dominated by steel or car companies anymore. And I‘d argue that change wasn’t entirely unpredictable.

The biggest constituent of MSCI World today is Apple at around 5%, followed by Microsoft at almost 4%. If I deviate from that by lowering their share by 2 percentage points each in my portfolio and invest that into other (much) smaller companies instead, how is that concentration? That would be additional diversification!

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Clearly, thats not investable but still:
https://www.msci.com/documents/10199/f7972c87-76f7-425b-9942-4e8929255210

Equal Weighting kind of matches Market Cap weighting. Not sure what of both actually came with a higher risk? A neutral holding probably was at 50% each…

One could argue that the 2019-2021 overperformance of market weighted indices aka US based corona-hype-tech-large caps was a matter of luck, meaning that we are bound to mean revert at some point in time.

And by the way - explain this:
https://www.msci.com/documents/10199/81912e51-32fa-418a-b30d-0f6c0782a93b

Yes, you concentrate on small caps more than you should :rofl:

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Oh you can do direct indexing if you really want, otherwise there is EUSA for example, that would simplify this task already significantly. This is not the point. Your data clearly shows that MSCI World Equal Weighted underperforms MSCI World during last 29 years. Market cap weighting is a natural one and it reflects earnings expectations of the whole market.

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