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I've asked this question before and consistently failed to get a clear answer - why is there any deviation between index fund weighting and market cap? To some

by AlanSE 7y ago

I've asked this question before and consistently failed to get a clear answer - why is there any deviation between index fund weighting and market cap? To some extent, I'm sure the definition of a "public" company comes into play. Not all stocks are traded in all exchanges, so you could include stocks only listed on one exchange. Then there's the practice of many index funds picking the top N stocks by market cap. This seems like a backwards practice to me. The small cap stocks should be limited in weight by... their small market cap. Then there are other hairy factors. Even out of the stocks in an index, it seems that weight does not correspond to capitalization. The reason seems to be some historical drivel. While I can understand that is the way it is, I fail to understand why it should be that way. Why should an equities index fund be anything other than public companies proportional to their size? If people prefer large cap or small cap, then those variations should be offered as special boutique products. But it seems that we have it backwards, where the default offering is based on arbitrary non-proportional weights, and with a cutoff restricting it to large cap.

id 7y ago
>The small cap stocks should be limited in weight by... their small market cap. A lot of index funds include small caps nowadays. Not all of them because it's more difficult to track 4000 versus 500 stocks. Also the more popular indexes have usually been around for a long time and have fewer constituents. >it seems that weight does not correspond to capitalization Pretty much all index funds invest in the public float and it makes sense: https://en.wikipedia.org/wiki/Public_float https://en.wikipedia.org/wiki/Public_float
- AlanSE 7y ago
  The public float sounds legit. I wouldn't argue with that, in fact, it's probably the technically accurate metric. Where I was coming from was... https://en.wikipedia.org/wiki/Dow_Jones_Industrial_Average https://en.wikipedia.org/wiki/Dow_Jones_Industrial_Average > The value of the Dow is not a weighted arithmetic mean[5] and does not represent its component companies' market capitalization, but rather the sum of the price of one share of stock for each component company. The sum is corrected by a factor which changes whenever one of the component stocks has a stock split or stock dividend, so as to generate a consistent value for the index.[6]. It is not an accurate representation of the US market or total market.[7][8][9] It mentions "consistent value", but that's over time. You can be misrepresented in weightings but still consistent over time. Basing the weightings on the stock price sounds royally stupid... if I'm even reading that correctly. But maybe this insanity is just the DOW? It's also the first one I grab for, because it's the first one that media reports on.
jonknee 7y ago
Why shouldn't there be lots of kinds of indexes? There are certainly ones like you describe. In practice it just doesn't matter, the large companies are so much larger that adding even thousands of tiny companies doesn't move the needle. VTI is Vanguard's total stock market ETF which works like what you suggest. It has 3,606 stocks, year-to-date it's up 18.82%. Compare that to Vanguard's S&P 500 ETF VOO which is up 19.03%. When a company hits its stride and is large enough to really make it difference it will join the S&P 500. I guess if there were a lot more than 500 companies that you should own there would be a problem, but we're not there currently. If you want exposure to small caps it's much more efficient to own an index of small caps. Their performance has seriously lagged in recent times though, so just owning VOO has been the way to go for a long time.

by AlanSE 7y ago

id 7y ago

>The small cap stocks should be limited in weight by... their small market cap. A lot of index funds include small caps nowadays. Not all of them because it's more difficult to track 4000 versus 500 stocks. Also the more popular indexes have usually been around for a long time and have fewer constituents. >it seems that weight does not correspond to capitalization Pretty much all index funds invest in the public float and it makes sense: https://en.wikipedia.org/wiki/Public_float https://en.wikipedia.org/wiki/Public_float

AlanSE 7y ago
The public float sounds legit. I wouldn't argue with that, in fact, it's probably the technically accurate metric. Where I was coming from was... https://en.wikipedia.org/wiki/Dow_Jones_Industrial_Average https://en.wikipedia.org/wiki/Dow_Jones_Industrial_Average > The value of the Dow is not a weighted arithmetic mean[5] and does not represent its component companies' market capitalization, but rather the sum of the price of one share of stock for each component company. The sum is corrected by a factor which changes whenever one of the component stocks has a stock split or stock dividend, so as to generate a consistent value for the index.[6]. It is not an accurate representation of the US market or total market.[7][8][9] It mentions "consistent value", but that's over time. You can be misrepresented in weightings but still consistent over time. Basing the weightings on the stock price sounds royally stupid... if I'm even reading that correctly. But maybe this insanity is just the DOW? It's also the first one I grab for, because it's the first one that media reports on.

jonknee 7y ago

Why shouldn't there be lots of kinds of indexes? There are certainly ones like you describe. In practice it just doesn't matter, the large companies are so much larger that adding even thousands of tiny companies doesn't move the needle. VTI is Vanguard's total stock market ETF which works like what you suggest. It has 3,606 stocks, year-to-date it's up 18.82%. Compare that to Vanguard's S&P 500 ETF VOO which is up 19.03%. When a company hits its stride and is large enough to really make it difference it will join the S&P 500. I guess if there were a lot more than 500 companies that you should own there would be a problem, but we're not there currently. If you want exposure to small caps it's much more efficient to own an index of small caps. Their performance has seriously lagged in recent times though, so just owning VOO has been the way to go for a long time.