Non-Market Cap Weighted Indexes: The Next Big Thing

I predict that within the next 10 years we will see a wave of new index ETFs and index/passive mutual funds. Almost all indexes currently available (and the ETFs and mutual funds that track them) are market-cap weighted. The technique that is usually used is that the stocks in some set (all Canadian stocks for instance) are sorted by their market capitalization (and other factors as well, but market cap is the dominating one). The index is then made up of the first n stocks in that list, where n is however many stocks should be in the index. These indexes may suit the media or other people interested in tracking “the market,”, but there are many disadvantages to using this form of indexing as an investment, and investing my money in market-cap weighted indexes is a very non-intuitive way to to invest. I have talked about some of the disadvantages of market-cap based indexes here: past articles. Non-market cap weighted indexes have a huge advantage over their market-weighted counterparts. I have discussed this in past articles using examples in the Canadian market and the US market.

I noticed the FTSE has recently created a whole family of non-market cap weighted indexes. Here’s the explanation why:

Why did FTSE launch non – market cap weighted indices?
We wanted to offer the market an alternative to wealth weighted indices and created non-market cap weighted indices to offer our clients a greater choice in market measurement.

It’s interesting that they the indexing community is still hooked on just offering their “clients a greater choice in market measurement,” not a greater choice of “investment.” In the future I can envision more semi-passive/passive indexes being created not for the purpose of “market measurement” or “tracking,” but solely for the ETF market. Or, we will see passive ETFs being created (without an “underlying index”) which will use passive indexing techniques (lower MERs) rather than active management (with higher MERs, which have proven to be a losing prospect in the past). They continue,

What is the difference between market cap weighted indices and non-market cap weighted indices?

The stocks within market cap weighted indices are selected according to market capitalisation (price x number of shares x free float) whereas stock in non-market cap weighted indices are selected according to a factors dependent upon fundamental data such as: book price, cash flow, revenue, sales, income and dividends.

Here they are talking about their selection criteria, which is in a way separate from the weighting-criteria. Using this selection criteria they mention is ok, however, I hope that they use equal-weightings or constant-weightings rather than weighting based on these criteria. Unforunately it is not possible to obtain the constituent stocks of these indexes at FTSE’s website.

In the US there is only one index, the S&P500 Equal-Weight Index, that I know of, and fortunately there is an ETF that tracks it, the Rydex S&P Equal Weight ETF. This funds takes it’s selection from the S&P500, however, meaning that there is a bias towards large-market cap stocks. The disadvantage of this is that some speculative stocks with unduly high market capitalizations (based on an overvalued stock) could make it into the index. What I would like to see is a family of indexes, all with equal weights for all their constituent stocks, but with different selection criteria for each index. We see this today, with Dow Jones’ style-based indexes, which are focused on value stocks, growth stocks, etc… however, these indexes are still market-cap weighted, unfortunately.

In Canada, there are no known style-based ETFs or non market-cap weighted ETFs. There is only a brokerage which tracks their own equal-weight S&P60 Index and sells shares in it to clients.

I can see non-market cap weighted indexes becoming more popular in the future, if only because of their better past performance. We all know people’s insatiable thirst for better performance, and it is clear that non-market cap indexes have given better performance in the past as I showed here and here. When the market has it’s next significantly large drop/crash, average investors will invariably sell positions in market-cap weighted ETFs and index funds and when the market comes around again, will look for other places to put their money, chasing performance. I think passive non-market cap based indexing will be the next big thing.

Here’s more support for the idea that the poor performance of the indexes in the past few years is related in part to the fact that they are market cap weighted (from the Big Picture):

Incidentally, the Efficient Market theory is the prime motivator behind indexing, which has been a losing propostion over the past few years (but I think thats more a function of market cap weighting than inefficient markets). [emphasis mine]

Maybe I’m talking out of my ass, but I am just not satisfied with using market-cap weighted indexes, nor am I satisfied with putting my money in the hands of a fund managers, whose ability to beat indexes consistently is questionable. Passive non market-cap weighted indexes lie somewhere in the middle and I really like the idea.

More links:

• At a recent conference, there was a talk entitled, “New Directions In Indexing.” Here’s the blurb: “Non-Market Cap Weighted Indexes for Portfolio Diversification and Enhanced Returns Carmen Campollo, SVP, Relationship Management, FTSE AMERICAS.” Looks like FTSE really is leading the way.
• The Dow Jones-AIG Commodity Index is non market cap weighted and is rebalanced annually. According to “Kevin,” on the Morningstar forums, “because commodities are so highly volatile (and not that highly correlated) the rebalancing bonus can be large–and you don’t even have to do the rebalancing work. Keep in mind that you only get the rebalancing bonus in a non market cap weighted index—more equal weighted as the AIG index is. In a market cap weighted index there is no rebalancing going on within the index.”