Is market capitalization the correct metric?

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Ben Mathew
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Re: Is market capitalization the correct metric?

Post by Ben Mathew »

NiceUnparticularMan wrote: Tue Jun 15, 2021 1:22 pm does it make sense for a personal investor to imitate just the part that they can see and imitate?
Theoretically, no. We can create a simple example with three assets: A, B and C. A is a risk free asset. B and C are perfectly negatively correlated. So if you hold B and C together, the fluctuations cancel out and it becomes a risk free asset, A.

10 people privately own B. On the stock market, they buy C to cancel out the risk.
5 people privately own C. On the stock market, they buy B to cancel out the risk.
5 people privately own A. On the stock market, they buy A to keep their portfolio risk free.

The publicly traded cap weighted market portfolio here would be 25% A + 25% B + 50% C. It's a risky portfolio that would not be optimal for anyone.
Last edited by Ben Mathew on Tue Jun 15, 2021 4:09 pm, edited 1 time in total.
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NiceUnparticularMan
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Re: Is market capitalization the correct metric?

Post by NiceUnparticularMan »

alex_686 wrote: Tue Jun 15, 2021 1:40 pm
NiceUnparticularMan wrote: Tue Jun 15, 2021 1:22 pm But then the question is--does it make sense for a personal investor to imitate just the part that they can see and imitate? And if that is a very incomplete imitation, then there is no particular reason for that investor to assume by only imitating that part, that they too have an efficient overall financial situation.
Maybe. I think it does.

So theory assumes perfect liquidity, information, etc. This is not true, of course. Even if it is mostly true - which I think it is - this leaves grey areas.

I advocate a modest overweight of REITs in the portfolio or around 10% to 20%. Real estate is part of the market basket, a good chunk of real estate is directly held so is not reflected in my traditional market cap indexes. I will acknowledge the shortcomings. Data on real estate is 2nd rate. Public REITs are a imperfect proxy for directly held real estate.

This is a partial answer. 20 years ago the limited data strongly suggested that one should hold REITs due to its low correlation to the overall market. The data today is more mixed.
Personally, I'm much more comfortable with the concept that at least most markets are efficiently priced in a way that doesn't make it actionable to try to find mispriced assets.

The concern I have about "missing" all the other assets and liabilities of market participants is more acute to me. I don't think it is quite as bad as Ben's example when talking about diversified stock portfolios, and again I think often it makes sense to just default to market portfolios in the absence of a good reason not to.

But when it comes to something like bonds? I think that is very much a problem, as we know market participants do all sorts of very specific things with bonds that make sense for them in light of their specific situation.

Real estate is sort of in between for me, and personally I do hold a small separate allocation to REITs (in addition to the REITs that come along in my stock indices) because I do tend to think that is getting me closer to a "market" investment in combined stocks and real estate. And real estate is a big enough area of capital investment in risky productive assets to make me think it might be worth not underweighting it too much.
Boglegrappler
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Re: Is market capitalization the correct metric?

Post by Boglegrappler »

Market cap weighting takes into account the market's forecast of growth, and market's assessment of risk. You hear a lot about the concentration of value in several large names, but that is because those names have the most sales, income, growth, or the least risk. Most of those articles never get into the underlying fundamentals.
Wedemeyer
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Re: Is market capitalization the correct metric?

Post by Wedemeyer »

The thing I still struggle with is the concentration of the weighting in few companies. It make sense to me that the market cap weighting is the market value of the price to pay today. But for investing, we want to diversify across assets that will grow in value to get the best return. The general consensus on this website is no one knows what the market will do on the future, other than the market will yield market returns. Using CRSP definitions, the market return is heavily (~70% in US) reliant on the 200 or so largest companies, ie the megacaps. Since no one knows if megacaps will outperform large (non megacap), mid, and small over a time period, then it is possible that large, mid and small could outperform the megacaps over a time period. No one knows.

So I land on tilts towards large (non megacaps), mid, small, and small value, which I feel is better diversification.

Your thoughts are appreciated.
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Re: Is market capitalization the correct metric?

Post by UKFred »

Any type of indexing other than market cap requires frequent trading to maintain itself. This would create a drag they would have to overcome for them to be ‘better’ than market cap indexing.
Wedemeyer
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Re: Is market capitalization the correct metric?

Post by Wedemeyer »

UKFred wrote: Thu Jun 17, 2021 10:27 am Any type of indexing other than market cap requires frequent trading to maintain itself. This would create a drag they would have to overcome for them to be ‘better’ than market cap indexing.
Don't the market cap weighted indices need to trade frequently to reflect the updated market cap sizes of the companies in the index? What is the difference?
NiceUnparticularMan
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Re: Is market capitalization the correct metric?

Post by NiceUnparticularMan »

Wedemeyer wrote: Thu Jun 17, 2021 10:11 am The thing I still struggle with is the concentration of the weighting in few companies. It make sense to me that the market cap weighting is the market value of the price to pay today. But for investing, we want to diversify across assets that will grow in value to get the best return. The general consensus on this website is no one knows what the market will do on the future, other than the market will yield market returns. Using CRSP definitions, the market return is heavily (~70% in US) reliant on the 200 or so largest companies, ie the megacaps. Since no one knows if megacaps will outperform large (non megacap), mid, and small over a time period, then it is possible that large, mid and small could outperform the megacaps over a time period. No one knows.

So I land on tilts towards large (non megacaps), mid, small, and small value, which I feel is better diversification.

Your thoughts are appreciated.
So I very much like thinking in terms of investing in ownership shares of assets, but consider the following.

Assume there are 1000 assets. They are not identical and have different risks, but let's just say when those risks are accounted for, they are all worth $1000 each. So, the total pool of assets is worth $1,000,000.

OK, so now assume three companies, A, B, and C. A owns 800 of these assets, and has a market cap of $800,000. B owns 160, and has a market cap of $160,000. And C owns the remaining 40, and has a market cap of $40,000. We're just assuming here the assets they owns determines their market value. We're also assuming away any liabilities for simplicity sake.

OK, You have $1000 dollars, and want to invest it in shares of these 1000 assets. And assume you have no reason not to just put $1 in each.

If you follow that logic, it implies you should buy shares of A, B, and C at market weights. So, $800 in A, $160 in B, $40 in C.

OK, you now argue, but I don't know if Company A will outperform B! Or B will outperform C! Why am I investing so much more in A than B, and B than C?

Well, in this model, if you invest more in C than market weight, you are concentrating your investment disproportionately in those particular 40 assets, rather than just doing $1 each. And by hypothesis, you have no reason to do that. Same with if you invest more than market weight in B.

I think this is all a pretty powerful logic. If you think of yourself as investing in the underlying assets, and think market cap is tied to those assets too, then it doesn't matter much whether companies are bigger or smaller, it just means they have more or less of the assets you are trying to invest in.

But, there may in fact be subtle ways in which this model is wrong. But before you vary from it, you will need good reasons to do so.
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Re: Is market capitalization the correct metric?

Post by NiceUnparticularMan »

Wedemeyer wrote: Thu Jun 17, 2021 10:39 am
UKFred wrote: Thu Jun 17, 2021 10:27 am Any type of indexing other than market cap requires frequent trading to maintain itself. This would create a drag they would have to overcome for them to be ‘better’ than market cap indexing.
Don't the market cap weighted indices need to trade frequently to reflect the updated market cap sizes of the companies in the index? What is the difference?
If the market cap of Stock A increases because of a relative price increase, or Stock B because of a relative price decrease, all you need to do is hold the same shares and your holdings will track up or down with those price increases.
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nisiprius
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Re: Is market capitalization the correct metric?

Post by nisiprius »

Wedemeyer wrote: Thu Jun 17, 2021 10:39 amDon't the market cap weighted indices need to trade frequently to reflect the updated market cap sizes of the companies in the index? What is the difference?
No. In fact market cap weighting is the only weighting that does not require trading to maintain the weighting.

If that doesn't make sense to you, keep thinking about it until it does.

When an index fund buys a stock, the market value of that stock doesn't become frozen in time at the price the fund paid. If the market value of the stock goes up, the stock the index fund already holds goes up. It doesn't need to do anything, it just happens. A cap-weighted index fund is self-tracking.*

People attacking indexing frequently assert that index funds need to buy more Apple if the percentage weight of Apple rises. This isn't so. I have seriously wondered if all of the people who say this actually believe it themselves.

That doesn't necessarily mean the transaction cost advantage to cap-weighted index funds is huge. Transaction costs ought to show up in a non-cap-weighted index as a failure to track the index properly after expenses are accounted for. RSP, the Invesco S&P 500 Equal Weight ETF, as of 5/31/2021 has had a 12.06% return since inception, while the index had a 12.54% return, an 0.43% lag. The current expense ratio is 0.20%. So there is a lag of -0.23% per year that isn't accounted for by the current expense ratio. It's hard to say how much might have been a higher expense ratio earlier, and I don't know what other things might account for the lag beside transaction costs.

But anyway, at first glance the transaction costs might have cost -0.23% per year. Or to turn it around, the benefits in lower transaction costs to cap-weighted VOO over the emphatically-not-cap-weighted RSP, might have been on the order of 0.23%. So it may not actually be very important.

*OK, there can be details. If a new stock is added to the index, the index fund needs to buy it. But because of cap-weighting, at the time when they need to be bought, they are cheap. If a stock leaves the index, the fund needs to sell it, but again that will usually be when the stock is cheap. If an existing company issues new stock then the fund needs to buy more shares.
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Wedemeyer
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Re: Is market capitalization the correct metric?

Post by Wedemeyer »

nisiprius wrote: Thu Jun 17, 2021 11:38 am
Wedemeyer wrote: Thu Jun 17, 2021 10:39 amDon't the market cap weighted indices need to trade frequently to reflect the updated market cap sizes of the companies in the index? What is the difference?
No. In fact market cap weighting is the only weighting that does not require trading to maintain the weighting.
It makes sense if the market was a constant list of the same companies. New entrants (IPOs), consolidations/mergers, and exits (de-listings, taking a company private) to market will require some trading to re-balance, correct?
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Re: Is market capitalization the correct metric?

Post by alex_686 »

Wedemeyer wrote: Thu Jun 17, 2021 11:55 am
nisiprius wrote: Thu Jun 17, 2021 11:38 am
Wedemeyer wrote: Thu Jun 17, 2021 10:39 amDon't the market cap weighted indices need to trade frequently to reflect the updated market cap sizes of the companies in the index? What is the difference?
No. In fact market cap weighting is the only weighting that does not require trading to maintain the weighting.
It makes sense if the market was a constant list of the same companies. New entrants (IPOs), consolidations/mergers, and exits (de-listings, taking a company private) to market will require some trading to re-balance, correct?
You actually have to do a fair amount of trading. The above list, and...

You need to reinvest all dividends back into the index. i.e., if company A issues a dividend you need to buy shares of all companies in the index.

Any changes in the free float shares due to the company issuing new stock, either by public offering, by employee compensation, or restricted stock being registered. Stock buybacks. Spin offs (maybe). Reorganizations (maybe). International stocks have a host of other issues based on where they are located. Plus of a host of other actions that I have forgotten about.
Former brokerage operations & mutual fund accountant. I hate risk, which is why I study and embrace it.
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jeffyscott
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Re: Is market capitalization the correct metric?

Post by jeffyscott »

alex_686 wrote: Thu Jun 17, 2021 12:16 pm
Wedemeyer wrote: Thu Jun 17, 2021 11:55 am
nisiprius wrote: Thu Jun 17, 2021 11:38 am
Wedemeyer wrote: Thu Jun 17, 2021 10:39 amDon't the market cap weighted indices need to trade frequently to reflect the updated market cap sizes of the companies in the index? What is the difference?
No. In fact market cap weighting is the only weighting that does not require trading to maintain the weighting.
It makes sense if the market was a constant list of the same companies. New entrants (IPOs), consolidations/mergers, and exits (de-listings, taking a company private) to market will require some trading to re-balance, correct?
You actually have to do a fair amount of trading. The above list, and...

You need to reinvest all dividends back into the index. i.e., if company A issues a dividend you need to buy shares of all companies in the index.

Any changes in the free float shares due to the company issuing new stock, either by public offering, by employee compensation, or restricted stock being registered. Stock buybacks. Spin offs (maybe). Reorganizations (maybe). International stocks have a host of other issues based on where they are located. Plus of a host of other actions that I have forgotten about.
Some numbers to compare: VTSAX turnover is 8%, according to M*, Invesco equal weight S&P 500 turnover is 26%, Schwab fundamental large cap is 13%. The turnover for total market is (at least recently) greater than that for the cap weighted S&P 500, VFIAX turnover is 4%.
okwriter
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Re: Is market capitalization the correct metric?

Post by okwriter »

nisiprius wrote: Tue Jun 15, 2021 6:18 am
Gaston wrote: Sat Jun 12, 2021 8:33 am...If anyone knows of reliable research on this topic, I would appreciate if you could post a source or a link...
This seems to be a reasonable exposition of the theory behind it. Mean-Variance Portfolio Theory

This seems to be standard, accepted classroom/textbook stuff in financial economics. What it means in the real world depends on how close the real world is to the assumptions and how sensitive the results are to small departures from the assumptions. Siegel, for example, in Stocks for the Long Run accepts it as legitimate, and then says that fundamental indexing is better because he himself espouses a "noisy market hypothesis" which differs from the assumptions and leads to a different optimum weighting.

The math is just slightly beyond my own understanding, but you can read the conclusions and then try to back up and figure out the assumptions that lead to them.

Notice that although the presentation uses the word "efficient" in a technical sense in financial economics, the phrases "efficient market" and "efficient market hypothesis" do not appear. The conclusion does not depend on the market itself being efficient.

Notice the presentation in the last few paragraphs near the end:
Interpretation of the tangency portfolio (market portfolio)
  • One-fund theorem states that everyone will purchase a single fund of risky assets and borrow or lend at the risk free rate.
  • If everyone purchases the same fund of risky assets, what must that fund be? This fund must equal the market portfolio.
  • The market portfolio is the summation of all assets. If everyone buys just one fund, and their purchases add up to the market, then that one fund must be the market as well.
  • In the situation where everyone follows the mean-variance method- ology with the same estimates of parameters, the efficient fund of risky assets will be the market portfolio.
How does this happen? The answer is based on the equilibrium argument.
  • If everyone else (or at least a large number of people) solves the problem, we do not need to. The return on an asset depends on both its initial price and its final price. The other investors solve the mean-variance portfolio problem using their common estimates, and they place orders in the market to acquire their portfolios.
  • If orders placed do not match what is available, the prices must change. The prices of assets under heavy demand will increase; the prices of assets under light demand will decrease. These price changes affect the estimates of asset returns directly, and hence investors will recalculate their optimal portfolio.
  • This process continues until demand exactly matches supply; that is, it continues until there is equilibrium.
Summary
  • In the idealized world, where every investor is a mean-variance investor and all have the same estimates, everyone buys the same portfolio, and that must be equal to the market portfolio.
  • Prices adjust to drive the market to efficiency. Then after other people have made the adjustments, we can be sure that the efficient portfolio is the market portfolio, so we need not make any calculations.
This does not mean that a cap-weighted total market index fund is the best investment in the real world, but it does explain why it has a special status and is the "level" from which we measure "tilts," and is not just an arbitrary choice. It's like the use of frictionless planes in physics, or points with no area in geometry.
It sounds to me like the assumption "every investor is a mean-variance investor" is the same as the efficient market hypothesis. If all investors are efficient, surely the market is, too.

But maybe I'm using "efficient" in the wrong sense.
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Re: Is market capitalization the correct metric?

Post by alex_686 »

jeffyscott wrote: Thu Jun 17, 2021 12:22 pm Some numbers to compare: VTSAX turnover is 8%, according to M*, Invesco equal weight S&P 500 turnover is 26%, Schwab fundamental large cap is 13%. The turnover for total market is (at least recently) greater than that for the cap weighted S&P 500, VFIAX turnover is 4%.
And to extend a bit, I am very relaxed about this.

Trading costs have dropped dramatically, in particular for ETFs. With trading costs, both implicate and explicate, basically at zero the impact of turnover is pretty much nil. As such, I don't think high turnover is a good argument against these indexes.

I favor market cap, but for other reasons.
Former brokerage operations & mutual fund accountant. I hate risk, which is why I study and embrace it.
Wedemeyer
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Re: Is market capitalization the correct metric?

Post by Wedemeyer »

So, turnover and trading exists in all indices and funds to some extent.

I think market cap weighted total market indices and funds are indeed the right metric and definition of the market and the standard benchmark to compare everything to.

But personally, for investing in a diversified portfolio for future returns, my struggle is still the weighting and effect of the megacap performance on the total market indices and funds. The megacaps are the biggest driver of market performance: 200 (5%) megacap stocks out of 3800 total US stocks, drive 70% of performance. However, being a megacap doesn't guarantee better performance compared to the non megacaps. My approach (last 15 years and next 20 years) is to hold the total market with a tilt towards large (non megacaps), mid, small, and small value. To spread the chips more evenly across the table, if you will. I feel this is better diversification, since we don't know what the future holds. I risk megacaps outperforming the non megacaps, and I understand this and I am willing to roll with this risk.

It's a bias of mine rooted in working for both small and large fortune 500 companies over time, and my experience with the large companies is one of inefficiency and bureaucracy that stifles innovation and growth.
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