Most index funds and ETFs (exchange traded funds) are driven by an underlying index. Most indexing companies use the market capitalisation (MCAP) method which has history going back to 1871.
The index funds and ETF industry have seen fast growth because active investing has underperformed the passive MCAP-based indexes. But while the MCAP method has brought clear distinction to active versus passive performance, it has also brought concentration, lack of diversification, and hence, it is not the best representation of what the financial literature defines as “market”.
And since the individual and institutional investors trust their life savings and passive investments with these MCAP indexes, more should be done to educate the investors about the harmful risks of concentration and the amplifying nature of MCAP.
MCAP weighting is the top indexing method both in terms of assets under license and also in terms of popularity. Trillions of dollars are invested using the MCAP method. MCAP is defined as the stock price multiplied by the number of float shares. MCAP is also known as the valuation of the company or its size.
All of the 500 components on S&P 500 are scored on size and weighted according to their proportional percentage in the aggregate weight. This proportion changes with every tick change in price.
What’s the MCAP indexing method?
An index can be understood as a basket. An index in stock markets is a basket of stocks. If the total basket value goes up, the index goes up, and vice versa. There are many ways to calculate an index. MCAP indexing method scores and weights companies on MCAP. So if a company is worth a trillion dollars and the total market value of the S&P 500 is 10 trillion dollars – this company, say Wapple, would be 10 percent of the total index value. And if a company, say Lapple has a value of $1 billion, it will be 0.01 percent of the total MCAP.
Every day when the Wapple price goes up, the 10 percent would increase further and every day when the Lapple price falls, the 0.01 percent would decrease further. Hence the bigger the size, the bigger the amplification. The smaller the size, the insignificant the decay.
Also Read: The pros and cons of investing in the Nifty Total Market Index Fund
Why can’t active managers with all their resources beat the MCAP method?
Active Managers can’t anticipate over the long term and beat the MCAP method because the selection, un-selection, timing of both the actions, is a probabilistic impossibility when compared to MCAP basket that does not have to anticipate, select, un-select or time. This probabilistic overhang is a job hazard for the active managers as selections (stock picking) is the only way they can charge fees.
“This probabilistic overhang is a job hazard for the Active managers as selections [Stock Picking] is the only way they can charge fees”
Anyone who has invested in Berkshire Hathaway from Jan 1999 till July 2020 could have done equally well by buying the SPY ETF. And if Warren Buffett, the world’s best investor has relatively long periods when he has not beaten the S&P 500, we can reasonably assume, that it is not really about the skill of an active manager to anticipate, it’s about his skill to do it recurrently over longer periods, when the game of anticipation gets stacked against him. You can beat the odds created by probability, for a day, for a year, for a decade, but you can not do it at an institutional level over longer periods. The only way to beat the S&P 500 consistently is by finding a probabilistic edge against the incumbent method.
Does the MCAP method use active underperformance as a unique selling proposition?
Investment solution today, are not bought, but sold. And if passive has a clear advantage over active, it would naturally use it for its advantage. This unique selling proposition has helped the ETFs and index funds industry grow fast to their 30th and 50th anniversary respectively.
Meanwhile, active managers have seen their market share decrease as the voice against active has become prominent over social media with journalists and the anti-active sentiment torch bearers making a deafening voice, screaming “Passive-Passive-Passive”, announcing its victory.
Also Read: Craze for index funds distorting market dynamics; passive investing no free lunch: Dhirendra Kumar
Is the MCAP method a good representation of the market?
According to the Passive Investing Businesses, the Passive school of thought and financial literature, the answer is a resounding “Yes”.
“Index is nothing more than a representation of the market portfolio.”
“MCAP method defines the Market”.
“MCAP method is the market”.
“It’s sacrilegious to question it”.
This resistance reminds me of the famous quote of…
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