A key tenet of Moller Financial Services’ investment philosophy is to utilize index funds to get low-cost exposure to the various asset classes that make up an investment portfolio. Because the index fund is a passive investment vehicle that simply attempts to match the return of whatever index the fund is tracking (such as the S&P 500 or Russell 2000), the costs of managing and administering the fund portfolio are quite low and can save investors a considerable amount of fees versus an actively-managed fund. These funds are also quite transparent and tax-efficient because they own most or all of the companies that the underlying index owns and tend to trade a lot less than actively-managed funds. However, there is more than one style of index available to investors. This article reviews the capitalization-weighted and fundamental-weighted indexing methods and discusses why owning both can be valuable to a portfolio.
The S&P 500 index—which tracks 500 of the biggest companies in America—is one of the most well-known indexes that uses a capitalization-weighting methodology. What this means is that each component in the index is weighted according to the market capitalization, or total market value, of that company. Market capitalization is measured by multiplying the price of one share of the company’s stock by the total number of outstanding shares available. For example, a company with 100 shares available that trade for $50 each would have a market cap of $5,000 (100 * $50). As of this writing, Apple is the most valuable American company, with a capitalization well over $2 trillion. The five most valuable companies included in the S&P 500 index, as of March 31, 2022, were Apple, Microsoft, Amazon, Tesla, and Google/Alphabet, with weightings in the index ranging from 2.5% to 7.14%. Due to their relative size and market value, these five companies make up nearly 24% of the total value of the index. The next ten largest companies make up another roughly 12% of the index. These statistics illustrate how concentrated the S&P 500 is in just a handful of companies, as only 15 of the 500 represent over one third of the index’s value.
Because the number of outstanding shares tends to change infrequently, the relative weightings in this index style are mostly based on the price movements of each stock in the index. Each quarter, the percentage of the index allocated to each stock is updated to reflect current market capitalizations. If Apple was 7% of the index and its stock price went up while the rest of the companies in the index had unchanged prices, then the following quarter Apple would perhaps represent 8% of the index. This simplified example illustrates one of the key risks with cap-weighted indexing: as a company’s stock price increases relative to others in the index (and thus gets more expensive), the index manager will allocate a larger percentage to that company, regardless of the company’s profits, outlook, or economic fundamentals. Think of this style as a momentum-based index, as the companies that have had the best relative stock price performance over the previous quarter will become a larger part of the index at the next rebalancing date. While momentum investing can work well in some environments—and has been on a decade-long run as high-flying growth companies have dominated market performance—there is risk involved in adding additional index allocation to the stocks that have done the best recently. Data from Research Affiliates show that the most valuable companies tend to underperform the rest of the market in subsequent time periods. Buying assets when they are relatively expensive and selling them when they are relatively cheap is counterintuitive to successful investing over time.
The main difference in a fundamental index versus the cap-weighted index is that the weighting of each company is not determined solely by market value. Keeping with our S&P 500 example, a fundamental index tracking U.S. large company stocks may look at the same universe of companies but allocate to each company in a different percentage compared to the cap-weighted version of the same index fund. These indexes tend to focus more on the economic footprint of a company as opposed to solely the market price. Metrics such as adjusted sales, cash flow, book value, and dividends/buybacks can all have an impact on the fundamental weighting while not having any direct effect on the capitalization weighting. Because there is some more analytical effort involved in this process, these funds tend to have underlying expense ratios that are slightly higher than their cap-weighted brethren but still significantly lower than actively-managed mutual funds or ETFs. When both index styles are blended together in an allocation, it is still possible to maintain a very low-cost portfolio with exposure to a globally diversified blend of equity asset classes.
This style of index can be thought of as a value-oriented approach to counteract the risk of overconcentration in the momentum approach described earlier. By decreasing the allocation to companies that have seen their stock prices outperform and potentially get ahead of their economic fundamentals while increasing the weighting to companies that have fallen out of favor and present more attractive valuations, this indexing approach can be a mechanism to buy low and sell high within the companies making up a given index.
We believe both cap-weighted and fundamental indexes are useful in an investment portfolio. There will be times when momentum-driven indexes perform better and others when value-oriented indexes outperform. We have seen an extended period over the past decade where cap-weighted indexes have wildly outperformed their value-oriented counterparts. However, this should not always be the case and the style of index that leads tends to be cyclical over time. Indeed, we have seen most fundamental index versions experience a significantly smaller drawdown than their cap-weighted counterparts over the first half of this year. By owning both styles within a portfolio, there is no need to predict the relative performance of each and try to outguess the market on a forward-looking basis.
In addition, owning both styles of index within a specific asset class allocation makes the opportunistic rebalancing process more efficient. Whenever we get a signal to sell some of an asset class in a portfolio, we can look to liquidate more of the index style that has performed better recently. Conversely, buy signals can be used to purchase the type of index that has fallen more out of favor within the asset class. For example, if an allocation target for U.S. large company stocks is 20% (split evenly between cap-weighted and fundamental) and the portfolio weighting falls to 18%, we would purchase more U.S. large company funds. If the fundamental index fund had held its value at 10% and the cap-weighted index had fallen to 8%, the entire 2% purchase to get back to the 20% target would be concentrated in the underperforming cap-weighted index fund. This provides a second level of rebalancing, as we can trade to keep asset classes in line with their long-term allocations but can also use the same strategy within asset classes to keep an even balance between cap-weighted and fundamental indexes.
It is nearly impossible to consistently predict whether cap-weighted or fundamental indexes will perform better over a short time period. Instead, we typically choose to own both styles within investment portfolios to ensure that our portfolios capture the periods of relative outperformance by each. This allows us to maintain low-cost, transparent, globally diversified, and tax-efficient portfolios without having to time the market or guess which style will be in favor in the coming months or years. Having two different indices in each asset class also increases the efficacy of our rebalancing and hopefully allows for better investment outcomes for our clients.
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