Market-cap weighting's greatest strength is also its greatest weakness

What many perceive as bugs in cap-weighting are actually a feature.

Ben Johnson, CFA 30 October, 2018 | 5:00PM

Market-cap-weighted stock index mutual funds and exchange-traded funds have grown tremendously in the past 40-plus years. There are several explanations for this growth: Investors are becoming more fee-conscious, asset management and advice are being unbundled, disillusionment with active managers has grown, and so on. But I'd argue the common driver behind these funds' growth is the lasting appeal of the attributes of market-cap-weighted indexing as an investment strategy (as opposed to just a means of measuring market or manager performance). I'll treat the main ones here in turn.

Diversified

Market-cap-weighted stock indexes are generally well diversified. I say "generally" because they are not all created equal. For example, some single-country indexes may capture a narrow and shallow opportunity set. Classic examples include markets like Finland. Per MSCI data, the MSCI Finland Index had a total market cap of just $200 billion as of the end of August. The top five constituents of the index account for 68% of its value ( Nokia (NOK), its largest constituent, has a 20.5% weighting) and three sectors (technology, industrials and materials) made up more than 60% of the benchmark.

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About Author

Ben Johnson, CFA

Ben Johnson, CFA  Ben Johnson, CFA, is director of global ETF research for Morningstar and editor of Morningstar ETFInvestor, a monthly newsletter.