Thinking Beyond Size: The Case Against Market Cap Weighting in Index Strategies

Anyone that paid mild attention to the news in 2023 has an idea where this post is going. From the half way point on the 2023 calendar it became clear what was driving the major indexes – the ‘magnificent seven’ stocks. Those stocks being – Apple, Microsoft, Meta, Google, Nvidia, Tesla and Amazon.

Before we go too far, let’s discuss market capitalization (cap) weighted indexes. Market cap is the total value of the outstanding stock of a company. The world of equity investors look at company size as a way to differentiate companies. From an index construction standpoint, many indexes makers use market cap to add weight to companies. For example, the S&P 500, Russsell 2000 and the Nasdaq 100 indexes add more weight to the largest market cap companies. This means that the bigger the company the more impact its performance will have on the index’s performance.

Returning to 2023, we see that the largest companies had outsize performance. The combined performance of the magnificent seven made up the majority of the 2023 return of the S&P 500. At some points in the year, the magnificent seven return was more than the S&P 500 Index. The other 493 stocks combined performance were a drag on the magnificent seven.

Why would you bother comparing your portfolio to such a benchmark? The action of 2023 is a perfect example of why investors should not compare to market cap weighted benchmarks. Personally, I don’t care about benchmarks to compare to. My goal as an investor is not to beat a benchmark. Rather, my goal is to buy great companies and earn a return on capital that will allow me to reach my financial goals.

If you are still convinced that you must compare to a benchmark then please use the S&P 500 Equal Weight Index. This index puts equal weight on all 500 stocks in the index. There is an easy way to track this index. Use the total return of the exchange-traded fund (ETF) that track this index – Invesco Equal Weight S&P 500 Index (Ticker:RSP).

A fun fact is that RSP was up 13.7% in 2023 versus the S&P 500 market cap weighted index being up 26.31%.

From this little example you can see that people using the wrong benchmark (wrong one being the S&P 500 market cap weighted index) will end up taking on more risk. How so? If your target is to beat the S&P 500, you will have to take on a fair amount of risk to clear 26.29%. Consider that the average annual total return of the S&P 500 over the 100 years ending 12/31/2023 is 10.54%. It stands to reason that beating the long-term average by 2x (2023’s return 26.9%) then you have to take more risk.

The other detriment to using poor benchmarks is to professional money managers. The sad truth is that the financial services’ industry benchmark is the S&P 500. There are plenty of sound money managers that did not beat (and never do) beat the S&P 500. That does not make them bad managers.

Be careful out there. Make sure if you are comparing to something it’s not market cap weighted. Cheers.

This website and associated newsletter along with its content/links are not financial advice. Nothing in this newsletter is an investment recommendation. All content is created for entertainment, educational, or informational purposes only. My strong buy, accumulate, hold, reduce or sell opinions are exactly that – opinions. Be sure to do your own research for your own particular circumstances or higher a professional advisor.

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