Equal-Weighting: An Alternative To The Standard Index

At first blush, weighting a stock index by market capitalization seems to make a lot of sense. After all, the goal of an index is to track the value of the stock market as an aggregate. What right does an index provider have to decide they know better than the invisible hand of the market when it comes to weighting the various stocks in the index? Passive investing is supposed to be just that – passive. And that’s exactly what market capitalization weighted indices do. They allocate resources based on the market’s judgement about each individual stock’s worth.

However, market capitalization based indices mean that as a stock’s value increases, it represents a larger portion of the index. Therefore, as Amazon increases in value, any new money allocated to the index is by its nature weighting Amazon more highly than before the rise. Does it make sense to buy more of a stock as it goes up in value? To some extent, grabbing hold of winning companies like Amazon seems like a good bet, but what happens when the market overpays for that growth? Surely there has to be a better way.

There are a whole myriad of different quantitative strategies that attempt to beat the simple market-cap based indices. Some indices weight the individual companies by a fundamental metric like revenues. Other strategies attempt to buy more of the less expensive companies by ranking them by price-to-book or some other filter. There are even those indices that use the number of employees to determine how to allocate to each company.

These strategies might work, but there is an even simpler one. How about not trying to predict which stocks will outperform and instead weight them equally? Surely something so simple can’t work. Or can it?

The Canadian Experience

Canadians have a unique perspective about the problems with market-cap based indices. During the Dotcom bubble, Nortel Networks rallied to the point where it represented 35% of the TSE 300 Index, which at the time was the primary Canadian benchmark. It was made even worse by the fact that its parent company BCE owned a big position in Nortel, and that it was trading as a Nortel-surrogate. When combined BCE and Nortel represented over 45% of the index.

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