The Pros and Cons of Market-Cap-Weighted Indexing

It’s not an ideal investment strategy, but it has been tough to beat.

The Pros and Cons of Market-Cap-Weighted Indexing

Ben Johnson, CFA

Apr 26, 2022

Mentioned: Vanguard Total Stock Market ETF (VTI)

How would you describe the ideal investment strategy? And no, “buy low, sell high” doesn’t count. Personally, I would describe the ideal investment strategy as having these six traits:

1) Diversified

2) Inexpensive

3) Tax-efficient

4) Has tons of capacity

5) Performs well over the long haul

6) Can be used well by investors

I’d argue that market-cap-weighted indexing ticks all these boxes. But while there’s a lot to be said for letting Mr. Market do most of the heavy lifting for you, there’s no guarantee there won’t be moments where you’ll second-guess the market’s wisdom and your decision to hitch your wagon to its every whim. Like any sound investment strategy, indexing won’t feel ideal at every turn in the market cycle. And indexing’s best attributes aren’t necessarily universal, especially as indexing has mutated from broad-market benchmarking to slapping together lists of stocks that may or may not have anything to do with the theme du jour—from artificial intelligence to Generation Z. Here, I’ll dig into the pros and cons of market-cap-weighted index funds in more detail.

Free Lunch

Economist Harry Markowitz gets credit for coining the concept that diversification is the only free lunch in finance. If diversification is a free lunch, then low-cost, total-market index funds are an all-you-can-eat lunch buffet. These funds own as many securities as they can within their respective investment universe and weight them according to their going value. As an investor, you can’t cast a wider net, and you can’t do any less work. Indexers are freeloaders. They can’t be bothered to lift a finger trying to figure out what something is worth. They leave that to the market.

But not all indexes are broad. The narrower the index, the less likely that investors will enjoy the full benefits of budging along with a benchmark. This is particularly prominent in less-liquid markets, like high-yield bonds and bank loans. Because index funds in these corners of the market have to place a premium on investability and liquidity, they often miss out on some of the richest veins in the investment opportunity set. These are areas where investors are often better served by savvy active managers.

Letting the market decide how to weight positions can also be a bad idea—at least sometimes. In the go-go days of the late-80s Japanese stock market, the MSCI EAFE Index at one point had 44% of its portfolio invested in Japanese equities. In the first quarter of 2000, the S&P 500 had 35% of its portfolio plugged into the bubbly technology sector. With the benefit of hindsight, we can say that this was bad for market cap-weighted indexing’s brand. Indeed, the bursting of the tech bubble was the event that launched 1,000 alternatives to market-cap weighting.

Less Is More

Market-cap-weighted index funds typically don’t charge much—if they charge anything at all. From investors’ perspective, this is ideal. After all, in the words of the late Jack Bogle, “In investing, you get what you don’t pay for.” Vanguard Total Stock Market ETF VTI is the exchange traded share class of the world’s largest index mutual fund, with over $1.3 trillion in assets. It charges a 0.03% annual fee. But VTI’s market price performance from its May 2001 inception through March 2022 lagged its spliced index by just 0.01% annually. This was thanks to a combination of savvy portfolio management and securities-lending income. For as close to next to nothing as you can get, Vanguard has delivered U.S. stock market returns to investors for decades.

But why pay anything? In August 2018, Fidelity launched a suite of zero-fee index mutual funds, among them Fidelity Zero Total Market Index FZROX. As the fund’s name implies, it charges nothing, and it has no minimum investment requirement.

The proliferation of low-cost index funds has been a boon for investors. But as fees have crept ever closer to or hit zero, their impact on these funds’ long-term returns has diminished. For example, from Fidelity Zero Total Market Index’s 2018 inception through March 31, 2022, it outperformed VTI by 0.10% on an annualized basis. Only a sliver of that outperformance can be explained by differences in the two funds’ fees. As expense ratios shrink, nuanced differences in index methodologies, portfolio management practices, and securities-lending programs will have a much greater influence on seemingly identical index funds’ long-term returns.

Tax Season

Market-cap-weighted indexes tend to have low turnover. All else equal, less turnover means less taxes in the form of taxable capital gains distributions. Broad market index funds have generally been far more tax efficient than their active counterparts. But that’s not always the case and is only partly attributable to their relatively lower turnover. There are plenty of index mutual funds that have pushed big tax bills onto their investors over the years.

The ETF wrapper adds a layer of protection from the tax man. Facilitating redemptions from the fund by pushing securities out in-kind shields ETF shareholders from the potential tax consequences of others’ liquidity needs. But this is an attribute of the ETF wrapper and not broad-market indexing.

No Limits

Broad-market indexes don’t bump up against capacity constraints the way that an active manager operating in the small-cap value space might. Sweeping in the full spectrum of securities in their investment universe and being price-agnostic means that broad-market index funds aren’t going to suffer from asset bloat as a shrewd small-cap stock-picker might. As such, investors needn’t fret that the next dollar being added to their total stock market index fund is going to damage the portfolio managers’ ability to deliver. Mr. Market is happy to take in that dollar, and the next one, and the next one.

But what about the effect of the torrent of flows into index funds? Should investors be alarmed over the programmatic buying by hordes of retirement savers? The only honest answer I can provide to this question is: I don’t know. But I do know that people have been slinging mud at indexing from day one, calling it “un-American,” “worse than Marxism,” blaming it for stifling initial public offerings, and more. And all these slights and “tail wags dog” arguments aren’t new. Long before index funds were the “tail,” market professionals fretted over “the mutual fund situation.”

I’m not convinced that the growth of indexing has been detrimental to markets or investors. If anything, any degradation in markets’ efficiency has likely been more than offset by the countless billions index investors have saved in fees, transaction costs, and taxes. If the day comes that the next dollar allocated to an index fund causes markets to go inside out, I have faith that there will be ample incentives for market participants to step in and fix things. I have faith in markets’ ability to self-heal—mostly because their ill health presents opportunities to profit.

Just Average

By definition, broad-market index funds are average. In any given year, about half of active funds will do better and about half will do worse. But over longer periods, being just average can lead to better-than-average outcomes—sometimes much better. Why is this? First, because index funds’ fee advantage compounds over time. Second, because most active funds don’t make it.

The data back this up. The Morningstar Year-End 2021 Active/Passive Barometer showed that over the decade through Dec. 31, 2021, just 26% of the actively managed funds available at the onset of that 10-year period managed to both survive and outperform their average indexed peer. Over longer time horizons, index funds’ advantage only compounds further. Sometimes being perfectly average is perfectly all right.

Relative Predictability

An ideal investment strategy is the one that you can stick with. But hanging tough is, well, tough. I’d argue that it is easier to sit tight if you know exactly what you’ve signed up for.

Relative predictability is a phrase attributed to Jack Bogle. The idea behind the phrase is that investment strategies may or may not perform as one would expect. In the case of index funds, they perform more or less exactly as you’d expect. If investors’ expectations are appropriately calibrated from day one, I think it is much more likely that they’ll stick with their strategy through thick and thin. It is hard to imagine a strategy that comes with clearer expectations than indexing.

Don’t Meet Your Idols

There is no ideal investment strategy—not even broad, market-cap-weighted indexing. Each and every strategy that’s ever existed—from the Nifty Fifty to whatever it is that Renaissance Medallion Fund does—has had strengths and weaknesses. Indexing has managed to outlast virtually all of them. Why? Because it is arguably the most futureproof of them all. The market portfolio doesn’t rely on a star manager. It doesn’t care about changes in accounting measures. It has seen stocks quoted in eighths and decimals. It predates the internet and will likely outlive Web 3.0. As long as companies issue public equity and debt as their primary means of raising capital and there are enough market participants pumping their opinions about those stocks’ and bonds’ values into their prices every day, it is going to be very difficult to come closer to an ideal investment strategy within most major asset classes than broad-market indexing.

Editor’s note: A version of this article previously appeared in the April 2022 issue of Morningstar ETFInvestor. Click here to download a complimentary copy.

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