Flaws of Market Capitalization Indices

by Manshu on May 16, 2010

in ETF

Today, Mr Credit Card from www.askmrcreditcard.com is going to drift away from his usual credit card rant. While he normally writes about airline credit cards or secured credit cards, today he is going to contribute a post about the flaws of market capitalization index.

Manshu is always talking and zooming in on the latest ETF news here. Today, I would like to chime in by talking about the flaws common in most ETFs in the market.

Market Capitalization Weighted – Since the beginning of modern portfolio theory that started back in the 1950s and 60s, one of the main premise was the the “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 rises, 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 and a stock drops out. The stock which is included would have seen a price run up and vice versa for the stock dropping off.

So here is the danger for folks to have a regular monthly investment program in an index like the S&P500 Spider ETF. 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 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&P500, 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 index – and in particular the debt government index.

While 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 and their respective finance companies fell into junk status, they became the largest debt issuers in the high yield index by a long mile. In fact, high yield managers’ outperformance or underperformance versus the index really depends 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. Because the developed nations government debt 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 have a very large weightings in the 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 is 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 an issue to investors of a stock market index during a bull market. But I fear that government bond indexes is 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.

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