Passive investing in stocks based on market cap

istock chart

One can passively invest one's whole stock portfolio based exclusively on market capitalization. The total market cap of a stock is price times the number of shares issued. For example, the percentage of the entire stock portfolio devoted to Microsoft would be the market value of all of Microsoft stock divided by the market value of all publicly traded stock in the world.

One way of passively investing one's stock portfolio exclusively by market cap is to place the entire stock portfolio in one broad index fund with both U.S. and foreign stocks. (Stock indexes weighed by market cap.)

An alternative to strict adherence to market cap is investment in several index funds (different slices of the stock universe) with automatic periodic rebalancing. For example, among the many stock index funds available are:

  • S & P 500 (large cap)
  • Midcap
  • Small-cap
  • European
  • Pacific
  • Emerging markets
  • Growth
  • Value

With an investment in several of these specialized index funds, one must decide the initial percentage of the stock portfolio to allocate to each fund. After making this initial decision, one can adhere to these percentages through automatic periodic rebalancing. That forces selling high and buying low.

To illustrate, suppose because of stock price changes, the Pacific Stock Index Fund comes to constitute a lower percentage of the portfolio than initially targeted, and the European Stock Index Fund is a higher percentage than target.

Automatic periodic rebalancing to target percentages forces one to sell the European Stock Index Fund (at a “high” price) and purchase the Pacific Stock Index Fund (at a “low” price).

(Rebalancing does involve transaction costs; the optimal interval between rebalancing is a complex question not addressed here. Also, I shall assume the investor does not engage in tactical asset allocation.)

Automatic rebalancing and index fund investing are both “passive” strategies in that the stock portfolio is on auto-pilot. Nevertheless, the two approaches are different. Indeed, a tension exists between them.

In contrast to automatic rebalancing, strict adherence to market cap generally forces the investor into a “momentum” approach: increasing investment in stocks appreciating in value.

To illustrate, assume a universe of only two stocks: X and Y, with equal market cap.

The investor buys $4 of an index fund that weights by market cap.

Indirectly, the investor holds $2 of X and $2 of Y. Assume that this X stock doubles in value to $4; this Y stock falls in value to $1.

This results in a portfolio that is 80% in X and 20% in Y.

By staying put in a market-cap-weighted index fund, the investor has increased investment in the appreciating stock and decreased investment in the falling stock — although there is not necessarily any reason to think that these stocks will continue to rise and fall, respectively.

A “momentum” investor (who believes that stock price trends tend to persist) would be delighted with a portfolio that is now 75% in the appreciating stock X.

On the other hand, an investor who has opted for periodic automatic rebalancing would sell X and buy Y to restore the original 50/50 allocation, thereby selling X “high” and buying Y “low, ” somewhat like a contrarian active investor.

(Even within a specialized index fund, stocks that appreciate will constitute a larger percentage of the portfolio. That will please momentum investors and displease contrarians.)

To provide a simple illustration, suppose one investor chooses to invest its entire stock portfolio in a total stock U.S. market index fund (perhaps one that mimics the MSCI U.S. Broad index). Another investor decides to invest its entire stock portfolio as follows: X% U.S. large-cap index fund (perhaps an S&P 500 fund), Y% U.S. midcap index fund and Z% U.S. small-cap index fund. X%, Y% and Z% reflect the current relative market caps of those three categories. The second investor also decides to rebalance to those ratios once a year.

The two investors will start with roughly equivalent stock portfolios. Assume that after a year, the large-cap index increases 20%, and the midcap and small-cap indexes each decrease 20%.

The first investor will stay put. To rebalance back to the initial ratios, the second investor will sell some of the large-cap index fund and buy more of the midcap and small-cap index funds. The portfolios of the two investors will diverge.

In advance, it is impossible to know for certain which investor will do better over time. Nevertheless, the periodic rebalancing has the advantage of forcing the second investor to sell “high” and buy “low.”

(Even if one's entire stock portfolio consists of just a single comprehensive stock index fund, one can automatically periodically rebalance among stocks, bonds, and “alternative” assets. This broad rebalancing would still provide a benefit. Nevertheless, the investor would lose the advantage of rebalancing among specialized stock index funds.)

In short, an investor has the choice between (1) one comprehensive stock index fund that weights by market cap or (2) several more specialized stock index funds. The latter permits more automatic periodic rebalancing to target percentages.

A tension exists between rebalancing and weighting by market cap.

William K.S. Wang is a professor at the University of California, Hastings College of Law