Quick, what’s the difference between a market-cap-, equal- and price-weighted stock market index? Fortunately, if you’re not sure, our friends at Dimensional Fund Advisors just published an excellent piece on this very subject. We invite you to read it here, but here’s our overview.

If you think of a market as a big box, there are several ways each stock that belongs in that box might “weigh in” to help fill it:

Market-Cap Weighted – If we fill a market box according to each stock’s market capitalization (share price multiplied by shares outstanding), the stocks with the biggest market caps (e.g., Apple stock –  AAPL) weigh the heaviest, or occupy the most space, as Dimensional depicted here:

Equal Weighted – If, each security is instead given equal space in the box regardless of its market-cap, an equal-weighted market will look more like this:

Price Weighted – As described in this recent New York Times piece (which may require a subscription to access), the Dow Jones Industrial Average is the only popular index that uses price weighting, where the highest-priced stocks take up the most space. (Almost everyone agrees, price-weighting is pretty arbitrary, especially since the Dow tracks only 30 U.S. stocks to begin with. But as the world’s first and oldest index, the venerable Dow essentially gets to do as it pleases.)

So what does all this mean to you as an investor? As Dimensional’s illustrations depict:

• If you were to invest all of your money in a single market-cap-weighted index fund, you’d end up holding a much heavier allocation to large-cap stocks, be they value or growth.
• If you were to invest everything in an equal-weighted index fund, you’d end up holding more small-cap stocks than would otherwise be warranted by their cap-weighted presence in the total market.

Now, here’s where things get a little complicated, so bear with me. At first glance, you might conclude you’d be best off investing in an equal-weighted index fund, to capture more of the higher expected small-cap value premium. After all, that’s where the biggest small-cap value “blob” appears, right?

Not so fast. First, we’ve got to remember that an index is just a theoretical collection of stocks. When an investor or fund manager seeks to replicate an index by placing actual trades on those stocks, they run into real-life trading constraints. This is especially so when tracking an equal-weighted index, where far more frequent trading is likely to be the norm.

Put plainly, keeping up with the evolving components in an equal-weighted index can get very expensive, very fast.

Dimensional explains:

“[U]sing a systematic and purposeful approach that takes into consideration real-world constraints is more likely to increase your chances for investment success. Considerations for such an approach include things like: understanding the drivers of returns and how to best design a portfolio to capture them, what a sufficient level of diversification is, how to appropriately rebalance, and last but not least, how to manage the costs associated with pursuing such a strategy.”

Which brings us back to evidence-based investing as we know it. Want to know more? Here’s a past post on index- vs. evidence-based investing. Or just give me a call to continue the conversation.

End notes:
Exhibit 1: For illustrative purposes only. Illustration includes constituents of the Russell 3000 Index as of December 31, 2016, on a market-cap weighted basis segmented into Large Value, Large Growth, Small Value, and Small Growth. Source: Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. See Appendix (on page 3) for additional information.

Exhibit 2: For illustrative purposes only. Illustration includes the constituents of the Russell 3000 Index as of December 31, 2016 on an equal-weighted basis segmented into Large Value, Large Growth, Small Value, and Small Growth. Source: Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. See Appendix (on page 3) for additional information.

Part of our job here at Hill Investment Group is to keep a relatively close eye on financial industry news, so our clients don’t have to (unless they find it interesting). One technical tidbit caught our eye recently when Vanguard’s advisor news channel reported on how its index funds will be impacted by a change to the way the Center for Research in Security Prices (CRSP) will be reconstituting its indexes.

Wow, that’s a lot of jargon. Let’s translate.

Most investors are familiar with the broad strokes of index investing. An index fund identifies a slice of the market to invest in – such as U.S. small-company value stocks. The fund manager then picks an index that tracks that same swath, and buys up essentially everything that index is holding. For the past several years, Vanguard has been using CRSP indexes to fulfill that role.

Mostly, that’s a relatively sensible way to go about investing. CRSP indexes are at least as robust as any others for tracking particular markets. And index funds are certainly better than active managers, who spend their time and your money trying to dodge in and out of markets, without adding expected extra worth.

If there weren’t an even better – let’s say best – way to go about it, we’d probably be all in on index funds ourselves (and there are times we use them, when we feel they are the ideal tool for the job at hand). But, instead of investing in funds that follow indexes that follow a swath of the market … we typically prefer funds that skip the index “middle man,” and buy into the vast majority of a market swath directly. Dimensional Fund Advisors is one such fund manager, and the longest-tenured among them, having been around since 1981.

Vanguard’s recent announcement speaks to one reason we prefer the more direct approach. One bugaboo index funds face is what to do whenever its underlying index “reconstitutes,” or changes the securities it’s tracking. Every index does this from time to time. For example, say a small company becomes a big company. A small-cap index must then stop tracking its stock and, usually, pick a different one to track instead.

That means any index fund tracking that index must actually sell and buy those same swapped-out securities – and relatively quickly if it wants to keep accurately reflecting its target index. You may already be a step ahead of me if you recognize that this creates some pricing challenges. If several index fund managers are all trying to sell and buy the same securities at around the same time, the trades can end up costing more than if there weren’t an essentially artificial supply-and-demand issue at play.

To help alleviate (although probably not eliminate) that challenge, CRSP has announced it will spread its reconstitution activities across five days instead of just one.

Again, that’s a sensible idea, and it may help some. But remember, fund managers like Dimensional allow us to avoid the reconstitution challenge entirely by more directly tracking the small-cap value market (and many others). This is a topic for another post, but direct tracking also offers other advantages over being tied to an index. Suffice it to say here that not all small-cap value funds are equally as effective at capturing the expected premiums available from this relatively narrow market.

So, with respect to Vanguard’s recent announcement, “better” is nice. But when the choice is, “better or best?” … we still prefer best.

Jack Bogle is a hero in our world. He launched the Vanguard 500 Index fund forty years ago in 1976. The initial reception was unimpressive, raising only $11 million, which was far short of the $150 million target. Critics called the index fund “un-American” and boring when compared to the active funds that were heavily advertised.

The S&P 500 Index fund gathered assets slowly in the beginning, but now is the second largest mutual fund in the world, with assets of over $255 billion. The total assets in all index and exchanged-traded funds is now $5 trillion. Investors have seen the evidence and are voting with their dollars. Happy Birthday Index Funds!

To read the full article please click here.