A closer look at market cap indices

Why would an investor want to use market-cap indices instead of other investment strategy-type indices? 

Market-cap indices are representative of the market portfolio, the portfolio that encapsulates the risk and return forecasts, and hence the investment choices of all investors across the world.

Although any market-cap index can only ever be a subset of the global market portfolio, they nevertheless provide a good representation of the choices of the ‘average’ investor.  For investors who consider themselves to be ‘average’, the market portfolio and hence a market-cap index, should be the starting point for investment discussions.

Investors who consider themselves to be different to the ‘average’ may have reason to deviate from market-cap indices. For example, some investors may have a requirement for short-term liquidity and are therefore fearful of exposure to illiquid assets and the securities of companies that may be at risk of bankruptcy. 

However, many of those investors who do consider themselves superior to the ‘average’ have learnt from experience that being consistently better is rare. Although there may be investment strategies that outperform market-cap indices over the short and even medium-term, achieving consistent outperformance over the long-term is likely to prove an unrealistic aspiration.

What are the benefits to the way market cap is constructed?

Market-cap indices depend on very few variables for their construction. In their purest form, these indices require only the share price and the number of shares in issue for each of the companies in the investment universe. 

Consequently, the ground rules for a market-cap index need concern themselves primarily with issues such as the definition of the investment universe, including the treatment of new entrants and the handling of the different types of corporate events. The resulting rules are simple, transparent and robust.  

What are the disadvantages, and how are these being addressed within the industry?

There are relatively few disadvantages of cap-weighting and those that became apparent in the early days of indexation have largely been addressed by the industry. The most notable of these was the need to move towards free-float weighting of stocks. This need became apparent when index managers and closet indexers, found difficulty in obtaining their required holdings of newly issued securities when large, often majority stakes, were retained by governments or founding families.

Today, there is a large cohort of index managers all desirous of achieving negligible tracking against their benchmark indices. Index providers including FTSE have fine-tuned their index rules to help make this achievable, for example by introducing liquidity screens and giving careful thought to the timing of the inclusion of corporate events.

What are some of the most common ways investors can personalise market-cap indices to better suit their needs?

Customisation is becoming an increasing part of the index providers’ business. There are many ways investors can seek to customise an index, of which the most basic is the definition of the investment universe. Some investors may wish to see the universe expanded to include additional markets or restricted because asset owners do not want to invest in specific industries for moral or religious reasons.

More recently, FTSE has experienced increasing demand for indices that incorporate the tax perspective of the individual investor. Taxes here can include withholding tax on dividends, which is usually treaty dependent, income taxes for the end investor, and capital gains.

Other trends include demand for investor-specific hedging strategies, alternative nationality definitions for specialist indices, capping methodologies, and off-cycle index reviews. The successful index providers of the future will all need to be capable of providing such ‘mass customisation’.

Market-cap seems to be under attack. Will it be replaced as the dominant type of index used in investment portfolios? 

Market-cap weighting is representative of the industry average. If any other weighting scheme becomes so successful that it comes to dominate the entire industry, by definition it will become the new average. For example if fundamental weighting were to become the new norm, fundamental weights would move towards cap-weights as investors bought more of the fundamentally cheap stocks and sold more of those that were deemed fundamentally expensive.

However, not all investors are ‘average’ and there is room for deviation for those who consider themselves different either through position or knowledge. Additionally, if these investors are also willing and able to ride out market dips, even crashes, they may earn an additional premium from structuring their portfolio to effectively be short volatility risk. We expect to see increasing demand for index customisation along these lines.

Another growth area is in that of investment strategy indices. Finally, there is an increasing range of indices that veer away from cap-weighting, towards equal weighting. 

However, the arguments used to justify the construction of more efficient indices are manifold. These include arguments for: return forecasts to be more closely related to risk; return forecasts to be discounted in favour of creating the most diverse portfolio possible; and for short-term rebalancing towards a specific weighting scheme. 

All this makes for interesting times in the world of indexation.