Market Capitalization Weighted indices have a significant structural flaw. Namely, they overweight your pricing errors when they are unfavourably wrong and they underweight your pricing errors when you are favourably wrong. Allow me to demonstrate with a simplistic example.
Let’s suppose we have 2 stocks in our stock market and that we magically know the true value (or fair value, or intrinsic value) of each. They each have a fair value of $10/share, but stock A has a stock market price of $20/share (market participants have bid the price up) and stock B has a stock market price of $5/share (market participants have bid the price down).
If we assume that the market is fairly efficient for the most part, then it isn’t crazy to see what would happen if the stock prices converged to their fair value prices ($10/share in both cases). First we have to see that our index is heavily weighted to Stock A which now represents 80% of our index ($20/share and a the total market is only $25). Stock B is similarly calculated to be only 20% of our index ($5/share out of a total market cap of $25 for the index).
If Stock A were to retreat from $20/share to $10/share, then 80% of our index will have lost 50% in value.
If Stock B were to increase from $5/share to $10/share, then 20% of our index will have gained 100% in value.
The net effect is that you will have lost 20% overall.
You Can Have Good Pricing Errors and Bad Pricing Errors
In this little example, our universe had only two stocks and in fact only two shares (one share per company). The company that was over-priced ($20 stock market price versus $10 fair value) had a very high weighting in our index simply because a market cap weighted index is constructed such that weighting is dictated by market cap (duh!). In this case we were over-exposed to this over-pricing error. The company that was under-valued ($5 stock market price versus $10 fair value) represented very little of our index, so our exposure to the stock that was going to go up was diminished.