Does Cap Weighting Produce a Flawed Index?

Weighting an index fund in different ways might or might not work, Vanguard founder says, but is it worth the added risk?

Mar 15, 2014 at 8:30AM

John C. Bogle is the founder and retired CEO of The Vanguard Group, the largest mutual fund organization in the world, comprising more than 160 mutual funds with current assets totaling more than $1.4 trillion. Since his retirement from Vanguard in 1996, Bogle has spent his time studying, writing, and speaking on the financial markets and mutual funds. He is president of the Bogle Financial Markets Research Center, created in 2000 to support his ongoing work on behalf of investors.

"Don't let past data impress you," Bogle warns. Experimenting with dividend-weighted, value-weighted, equal-weighted, or other types of indexing might work for a while, but given the nature of the market, anything that outperforms long enough will attract other investors away from the market-weighted index, and the opportunity will vanish.

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Tom Gardner: If we take the concept of "too big to succeed" and apply it to a capitalization-weighted index fund, isn't that a bad idea? Wouldn't it be better to set the index fund up on a different set of criteria, rather than weighting it by capitalization?

Aren't we buying the largest companies and the most successful companies, which should have the smallest future market opportunity, and underweighting the small, potentially upstart, disruptive future Vanguards?

Jack Bogle: Well, you're saying that the cap-weighting indexes give you a flawed index, in effect.

I guess my first comment would be, since such an index beats the heck out of money managers, what kind of trouble would we be in if there were a perfect index? Then I'd also say, much more importantly than that; the idea of indexing, as Paul Samuelson described it when he wrote the foreword to my first book, was, "You will get better returns than your neighbors and sleep better than your neighbors" -- and your neighbors own the capitalization-weighted index.

Now, will a value-weighted index do better? Will a dividend-weighted index do better? Probably it will do better some of the time. I do not believe it will do better in the long run. That remains to be seen.

But when you think about it, if "fundamental indexing," -- whatever that means exactly, but a weighting by some corporation data, rather than by market price -- still owns essentially all the stocks that the S&P 500 owns, with just somewhat different weights; not huge, but somewhat different weights. They may do better, they may do worse.

But if they continue to do better, what will happen? Everybody will take their money out of the market-weighted index and put it into the value-weighted index, and then the opportunity will vanish. That's the way the markets work.

I don't think it's going to work, and I don't think that it's worthwhile to add that risk. I know what I can get. I can do better than my neighbors. I can own the whole market -- that's a little beyond the S&P, but that's a perfectly good way of looking at it -- do better than my neighbors.

Should I give that -- let's call it "certainty of relative return" -- up for the uncertainty of whether one of these schemes that's out there? Equal weighting, value weighting, dividend weighting, fundamental weighting, all kinds of weighting ...

Gardner: I feel like equal weighting would be smart, but I guess time will tell whether that plays out.

Bogle: It works sometimes; we have data going back forever.

But don't let past data impress you. When people start actually doing these things -- you know this from your own experience -- what comes out of the lab is seldom reflected in the real world.

John Mackey, co-CEO of Whole Foods Market, is a member of The Motley Fool’s board of directors. The Motley Fool recommends and owns shares of Chipotle Mexican Grill, Costco Wholesale, and Whole Foods Market. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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