Author Topic: Are market cap weighted indexes just a form of momentum investing?  (Read 5013 times)

leostrauss

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i don't understand what is special about market cap weighting and why bogleheads are so in love with it. Given that cap weighted index funds have to keep buying whatever stocks have gone up lately and sell whatever stocks underperformed it looks to me that it is simply momentum investing masquerading as some sort of neutral stance that is above the fray. To me it seems like just yet another scheme of wringing returns from the markets no different than value weighting or equal weighting. Please explain to me how market cap based indexing is not a momentum play applied to the whole market.

forummm

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Re: Are market cap weighted indexes just a form of momentum investing?
« Reply #1 on: July 26, 2015, 05:28:22 PM »
Given that cap weighted index funds have to keep buying whatever stocks have gone up lately and sell whatever stocks underperformed

No. There's no buying and selling based on price movements. That's one reason why indexing is so cheap. If you have one share of every company in the index, you just keep holding one share of every company, regardless of whether the market price of the share doubles or drops 90%. Very cheap to do.

matchewed

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Re: Are market cap weighted indexes just a form of momentum investing?
« Reply #2 on: July 26, 2015, 06:52:12 PM »
Yeah turnover rate for VTSAX is 2.9%. There isn't much buying and selling going on there.

bigchrisb

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Re: Are market cap weighted indexes just a form of momentum investing?
« Reply #3 on: July 26, 2015, 07:09:23 PM »
I agree with the turnover arguments.  Cap weighted funds don't buy and sell with market movements, just with issuance or removal of new equity in the index.  This means that there is very little buying and selling.

Its unique to cap weighted indexes - other weights (such as fundamental, value, equal) all result in higher transaction volumes, and hence higher costs (both in transaction and in taxation). 

The low turnover inherent to cap weighted funds, and the corresponding low cost (both MER and underlying) is the main reason they are the cornerstone of my portfolio.

forummm

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Re: Are market cap weighted indexes just a form of momentum investing?
« Reply #4 on: July 26, 2015, 07:25:11 PM »
Just to put the words of the previous posters into different phrasing (in case you aren't familiar with the terms), an index fund like VTSAX only buys stock when people put more money into the fund or when a new stock is added to the index that VTSAX tracks. And only sells stock when people take money out of the fund or when a stock is removed from the index that VTSAX tracks. In practice, each day the people putting money in and people taking money out are trading ownership of shares, and only the amount that the new money exceeds the amount of money leaving is actually purchased by the fund. This minimizes trading even more.

Scandium

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Re: Are market cap weighted indexes just a form of momentum investing?
« Reply #5 on: July 27, 2015, 07:26:24 AM »
As people discussed this I was looking at some ETFs. Does anyone know where to find turnover % and number of stocks in an ETF on Morningstar? I only see turnover for mutual funds.

CorpRaider

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Re: Are market cap weighted indexes just a form of momentum investing?
« Reply #6 on: July 27, 2015, 11:54:49 AM »
I have sometimes thought that as well, based on all the research showing any alternative weighting methodology (and even the inverse thereof) outperforms, all else being equal (of course a big part of that is getting the trading and tax costs low enough so that they don't swamp the outperformance).  Arnott and RAFI have published some stuff that is relevant to this. 

The fundamentally weighted indexes are potentially attractive because they don't need to have materially higher turnover.

Most Bogleheads do have another asset class in their portfolio and recommend rebalancing, so that would counteract some of the momo/glamour tilt.
« Last Edit: July 27, 2015, 12:08:44 PM by CorpRaider »

Reido

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Re: Are market cap weighted indexes just a form of momentum investing?
« Reply #7 on: July 31, 2015, 07:32:32 PM »
I second corpraiders sentiment. I believe that if you back test an equal weighting to all of the sector spiders ETFs especially prior year 2008/2009 and rebalance them annually you will find they outperform the total market funds. It's not so much that there is buying/selling going on as much as there is constantly over representation of the sectors that are in favor, and when they go out of favor they cause a greater drop in the market.  I no longer have an etfreplay account but in sure someone else might be able to check this out

hodedofome

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Re: Are market cap weighted indexes just a form of momentum investing?
« Reply #8 on: July 31, 2015, 09:21:15 PM »
Reido I have an ETFReplay sub and I can confirm what you say here. It's a slight outperformance but has happened in the past. When you have uncorrelated returns, rebalancing helps.


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a1smith

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Re: Are market cap weighted indexes just a form of momentum investing?
« Reply #9 on: August 02, 2015, 09:15:45 PM »
Just to put the words of the previous posters into different phrasing (in case you aren't familiar with the terms), an index fund like VTSAX only buys stock when people put more money into the fund or when a new stock is added to the index that VTSAX tracks. And only sells stock when people take money out of the fund or when a stock is removed from the index that VTSAX tracks. In practice, each day the people putting money in and people taking money out are trading ownership of shares, and only the amount that the new money exceeds the amount of money leaving is actually purchased by the fund. This minimizes trading even more.

Actually, there is another time that VTSAX buys/sells stock -- when the index it follows rebalances to compensate for market capitalization (due to company share changes, not price change) of the constituent companies.

VTSAX follows CRSP US Total Market Index (CRSPTM1).  CRSPTM1 is rebalanced quarterly, you can find the rebalancing calendar here.  VTSAX will make adjustments to holdings at those times in order to continue tracking the index.

If you look at CRSP's Methodology page you will see that
Quote
Emphasis is placed on minimizing unnecessary index turnover while maintaining “style purity.”

EDIT - added (due to . . . )
« Last Edit: August 03, 2015, 05:42:53 AM by a1smith »

milesdividendmd

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Re: Are market cap weighted indexes just a form of momentum investing?
« Reply #10 on: August 03, 2015, 03:17:15 AM »

I second corpraiders sentiment. I believe that if you back test an equal weighting to all of the sector spiders ETFs especially prior year 2008/2009 and rebalance them annually you will find they outperform the total market funds. It's not so much that there is buying/selling going on as much as there is constantly over representation of the sectors that are in favor, and when they go out of favor they cause a greater drop in the market.  I no longer have an etfreplay account but in sure someone else might be able to check this out

Fundamental or equal weighted indexes will generally outperform cap weighted indices before costs for a simple reason. They Accept more risk in the form of a higher exposures to the the value and size factors (stock exposure will be on average cheaper and smaller in such indices.)

Funds tracking such indices will also always be more expensive than their cap weighted counterparts for a simple reason:  they require more transactions to rebalance the fund.

Imagine the S&P 500. If GM represents 2% of the S&P 500 on January 1, then a capitalization weighted fund will own exactly 2% of GM.

On the other hand an equally weighted index will hold 0.2% of GM (1/500 of the index)

Now if GM grows to become 3% of the S&P 500 this growth will be reflected in the stock price of GM automatically (and in the stock prices of other companies in the index that have shrunk relative to GM.) The Cspitalization weighted index need do nothing, it is already automatically rebalanced by price movement.

The equal weighted index on the other hand must sell some GM stock and buy some of the other stocks that have become relatively less valuable in order to maintain equal weighting.  This costs money in the form of transaction costs, capital gains, bid/ask spreads, and impact costs.

In other words capitalization waiting is always cheaper, and fundamental weighting or equal weighting are simply quantitative ways to pursue value or size exposures, much like adding small value/funds to your portfolio.

No free ride. And also note that cap weighting has zero exposure to the momentum factor (or the value or size factors) as suggested in the original post.