Weighted Index Funds

[Jerry1]

This article is about how index funds, like the S&P are weighted. It describes how when you buy the index, you are disproportionately invested in companies like Tesla. Not saying the advice in the article is good, but would like to discuss the implications of owning a weighted fund. Personally, I don’t like having so much, in percentage terms, in so few companies. I think of an index fund as being more broad and it’s really not.

Maybe a thing to do is to buy some other funds that are industry specific or capital size (small cap) specific to complement an index fund.

What are the thoughts from this group?


https://www.marketwatch.com/story/why-index-funds-are-nuts-11618425937

 

[RobLJ]

I have had some of the same concerns, and the most obvious "fix" are the equally weighted funds. These generally (I believe, but check) have underperformed, like foreign.
I suspect the dogs' day will come--but when?

 

[bloom2708]

If you buy the total market index, that is the market. Stuff happens today. At the end of the day that is the market. Tomorrow, the next day.

By going to the equal weighting or some other weighting you are saying the market has the wrong allocation/mix every day.

Yes, people buy Tesla and the index reflects that each day. If Tesla goes from #3 to #5, the market reflects that. There is a new #3.

Many people tilt, but to me it buying the anti-market. Today it is wrong. I think tomorrow it will be more like this tilt. Difficult unless you stick with tilts for long periods of time.

 

[Chuckanut]

This article is about how index funds, like the S&P are weighted. It describes how when you buy the index, you are disproportionately invested in companies like Tesla.

Are you certain about investing in Tesla? I thought it went belly up in in 2019 as predicted by many financial experts.

https://www.digitaltrends.com/cars/tesla-is-dying-and-this-is-how-it-will-end/
https://www.forbes.com/sites/jimcol...assively-as-a-public-company/?sh=2c4eef761dc2
https://www.thedrive.com/tech/24261...on-of-debt-why-tesla-will-go-bankrupt-in-2019

OK. I know.

My point is that even the most sophisticated don't know what will happen, that's why indexing is so popular. Indexing is the shield of those who are wise but also ignorant of the future.

 

[Out-to-Lunch]

this article is about how index funds, like the s&p are weighted. It describes how when you buy the index, you are [-]disproportionately[/-] proportionately invested in companies like tesla.

Fify

 

[Jerry1]

this article is about how index funds, like the s&p are weighted. It describes how when you buy the index, you are [-]disproportionately[/-] proportionately invested in companies like tesla.

Fify

I get your point, but why would I want to own a weighted mix. If I wanted to diversify, why wouldn’t I want one share of every company, or $1 of every company? Weighting seems to drive more money in the direction of the most successful industries. While that sounds good, it’s not diversification. You’re not going to gain the benefit of, for example, the hospitality industry as it comes back.

I’m not arguing against weighting, just trying to understand why it’s what I want. It worries me that as an index holder, I have so much exposure to the FAANG companies, for example.

 

[big-papa]

I get your point, but why would I want to own a weighted mix. If I wanted to diversify, why wouldn’t I want one share of every company, or $1 of every company? Weighting seems to drive more money in the direction of the most successful industries. While that sounds good, it’s not diversification. You’re not going to gain the benefit of, for example, the hospitality industry as it comes back.

I’m not arguing against weighting, just trying to understand why it’s what I want. It worries me that as an index holder, I have so much exposure to the FAANG companies, for example.

You have permission to own whatever you want.

As others noted, there is a definition chosen for what "the market" means. The total US market consists of $X of capitalization. Each stock that makes up that market has a certain percentage of that $X. So companies with larger market caps hold a higher percentage than companies with smaller capitalization. Index funds that track the Total US Market simply mimic this by tracking nearly all US stocks in the same proportion. Then mutual funds/etfs hold individual stocks in the same proportion. "Nearly" because who wants to hold 0.0001 shares of some stock at the bottom of the market cap list when it will make almost zero difference in the end? So many index providers use sampling techniques to get "close enough".

Diversification - This has become something of a slippery word used a lot of different ways by different people. One measure of diversification is called the "diversification ratio". It's a decent concept to compare groups of assets. Simply put, it's is the ratio of the weighted average of volatilities divided by the entire portfolio volatility. The more complex answer, if you're mathematically inclined, is found here, among other places: https://www.tobam.fr/wp-content/uploads/2014/12/TOBAM-JoPM-Maximum-Div-2008.pdf

If you start with a group of assets whose returns are not perfectly correlated and add one more asset, also not perfectly correlated, you will increase the diversification ratio. But there comes a point where continuing to add more and more just doesn't move the needle much anymore. By this line of thinking, you don't need the entire universe of US stocks to get to nearly the same level of diversification as the total US market.

Some caveats - like many things involved in investing, it is only backwards looking because it depends on measured volatility and correlation over some time frame in the past. So you can't accurately predict what holdings you should have in the future that would maximize diversification. That means that the answer will be different when looking over one time period vs. another. Also, just because a portfolio has had a maximum diversification doesn't mean it has had maximum returns. It just means that it has an optimal amount and weighting of independent contributors to the total return.


Cheers,
Big-Papa

 

[WhenIsItTime]

I agree with the OP that the S&P 500 market weighting is significant and probably not appreciated by most investors. At March 31, 10 stocks make up ~26%:

-Apple 5.7%
-Microsoft 5.3%
-Amazon 3.9%
-Facebook 2.1%
-Alphabet A&C 3.6%
-Tesla 1.5%
-Berkshire 1.5%
-JP Morgan 1.4%
-JNJ 1.3%

Although, this is somewhat messy as Berkshire made majority of its profit in 2020 through investments in other stocks including Apple.

Given strong recent returns, I am putting small portion into mid/small cap space for this reason.

 

[38Chevy454]

I agree with the article analysis, but I am not so sure that is bad? It does have less diversification than probably most believe. But it also has a reason for this, those stocks have performed well and the index distribution reflects that. It works for me, and I have several index type funds to go with my S&P 500 funds. That provides a little more to get away from the biggest stocks.

 

[Out-to-Lunch]

I get your point, but why would I want to own a weighted mix. If I wanted to diversify, why wouldn’t I want one share of every company, or $1 of every company? Weighting seems to drive more money in the direction of the most successful industries. While that sounds good, it’s not diversification. You’re not going to gain the benefit of, for example, the hospitality industry as it comes back.

I’m not arguing against weighting, just trying to understand why it’s what I want. It worries me that as an index holder, I have so much exposure to the FAANG companies, for example.

Here is a classic treatise on why cap weighting is most efficient:
John Norstad's proofs

 

[JRon]

The article has a great point about standard S&P index funds being heavily invested in 6 stocks. No one knows what the future of these stocks will be, but they are trading at so many time earnings that it’s possible they are at unsustainable prices. The Total Market index funds give a bit more diversity, but take a look at something like the Vanguard Dividend Growth Fund to diversify a bit from the FAANG stocks.