The advantages and disadvantages of indices weighted by market capitalization
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What is market capitalization
Market capitalization represents the current valuation of the traded company shares (the traded equity) on the stock exchange. For each company, the shares issued are multiplied by the current price per share to calculate the traded market value. The absolute value of market capitalization is thus measured by the total number of shares traded and also by the absolute value of the equity valuation. Large companies with a high absolute value due to high absolute sales, profits and book values have a correspondingly higher market capitalization than smaller companies.
Weighting by free float market capitalization in an index
The weighting in an index is based on the ratio of the value of the individual companies to the total of all companies considered. Large companies have a correspondingly high weighting.
However, most indices are not weighted according to absolute market capitalization, but adjusted by the proportion of free float. Free float refers to publicly traded shares, excluding share packages held by major shareholders above a minimum percentage (e.g. > 5%), insiders, preferred shares with special rights or shares held by the company itself (treasury shares). Weighting with free float adjustment is very useful, as it ensures that this part of the market capitalization is actually tradable on the stock exchange. This method is used by all major index providers (MSCI, FTSE) and also by most well-known indices (e.g. DAX, S&P 500). As a consequence, the weight of companies with higher free float is also higher in the index.
Characteristics of weighting by market capitalization
The weighting by market capitalization can be mapped very easily by ETF funds, because after a one-time purchase of all shares, the market capitalization behaves synchronously with the value of the shares. It is therefore a very cost effective option as very few transactions are required for rebalancing according to slightly changing free float shares. Furthermore, the weighting according to free float and market capitalization additionally ensures that liquidity is relatively high.
Market capitalization as a model of the market has certain effects. Since the value of the shares also prices in the future development of corporate profits, companies with positive expectations for the future are weighted higher. In addition, the weighting depends on the absolute values of the profits and thus on the size of the companies and not on the relative profit development. If, for example, Apple is able to increase its return on equity by one percent, this has a much greater weighting than for a small company.
Market capitalization includes in the price all future forecasts including growth prospects, profitability and risk, both at the level of individual companies and for cross-country and cross-regional indices. It thus includes the current valuation level, which is reflected in the price traded for the future that market participants are currently willing to pay.
Different countries, different market capitalizations
There are strong differences in the market capitalization of different countries. In the USA, for example, a large number of companies with a high free float are listed on the stock exchange. In Germany, on the other hand, there are proportionately many more privately and state-owned companies. In addition, there are significant historical differences in the valuation levels of different countries. These arise, for example, as a result of:
- Investor behavior and asset structures of private and institutional investors, often referred to as “home bias”. For example, there are regional differences (also due to regulation) in which assets pension funds, insurers and other institutions invest.
- Differences in interest rates, currency effects, loan conditions etc., which affect the cost of capital for companies
- Country-specific risks, such as political stability, property rights, freedom and regulation of markets, etc., lead to differences between valuation levels for different countries
Simply put, identical companies are valued differently by the market if they are domiciled and listed in one country or another. The result of all this is, for example, that in recent years the market capitalization of the USA has in some cases been well over 100% of GDP, while that of Germany has only been around 50% of GDP. Excursus: The measure capitalization / GDP is often referred to as the “Buffet indicator” and is used to measure the current valuation level and for forecasting future returns.
Summary of advantages
- Low costs and high liquidity
- Clarity: good companies and profitable markets are also highly valued
- Risks, profitability and growth expectations are priced in at all times
- Easy mapping in the portfolio, due to large selection of indices and fund products
There are clear drawbacks:
- Dependence on very large companies, especially highly valued and large growth stocks, and dominant sector developments, currently for example a clustering by large technology companies from the USA.
- Dependence on highly valued markets, e.g. currently the USA or Japan in the 1980s, and thus on regional bubbles.
- In some cases, high correlation between stocks and markets and thus possibly lower diversification.
Composition and characteristics of the benchmark index MSCI ACWI IMI
Taking the MSCI ACWI IMI as the market capitalization weighted benchmark index for the global exchange traded economy, as it covers 99% of the global market capitalization with about 9100 positions, we can analyze the following data (as of 03/23):
- The largest 6 positions are US Tech companies (Apple, Microsoft, Alphabet, Nvidia, Tesla) with a total of approx. 10.8%.
- The investment style of the ACWI IMI is currently relatively balanced by growth and value stocks (approx. 27% each).
- Company size: 78.7% large companies, 8.4% small and very small companies.
- Regional weighting and valuation level according to Shiller P/E ratio (CAPE):
| Region | Weight | Shiller P/E ratio (CAPE) |
| MSCI ACWI IMI | 100 % | 23 |
| Developed Countries | 89,5 % | 24 |
| Emerging Markets | 10,5 % | 14 |
| North America USA Canada | 62,2 % 59,0 % 3,2 % | 28 |
| Europe UK Switzerland France Germany | 17,1 % 4,2 % 2,8 % 2,6 % 2,0 % | 18 |
| Asia Japan China Taiwan India Korea | 16,4 % 5,9 % 3,2 % 1,7 % 1,5 % 1,3 % | 15 |
Summary
Simply put, you can’t go far wrong with a market capitalization weighting and, if you want to avoid increased complexity in your portfolio, you don’t have that many alternatives. This means you are in on all the good developments, but you also run into every bubble, especially in the case of the highly weighted positions, if the positively priced-in future scenarios do not materialize. In any case, the representation of the world economy by the MSCI ACWI IMI Index is biased to a significant degree in terms of large companies, high valuations and in terms of country allocation. We will look at interesting alternatives to build a world portfolio in upcoming posts.