In a recent post about market-cap weighted fixed income indices, it was noted by reader Xenko that one way to overcome overweighting overvalued companies and underweighting undervalued companies (counter to what a rational investor would desire) could be to inversely weight constituents of an index. While the original post was about fixed income indices, I’m assuming the thought was directed at equity indices so I will speak directly to that (there is an extra step with respect to fixed income indices that we’ll go over some other time).
Here is the problem with that suggestion: if you assigned more weight to a company based on its inverse cap-weighted rank then you run into the problem of running up the price of smaller cap stocks. A large market-cap stock might be worth $50 billion and is highly liquid. If it is the largest stock by market cap in an index it will have the most weight. But if the smallest company in an index (say with a market cap of $100 million) had the highest weight then if there were a lot of people trying to track that index their might be additional pressure on that stock’s price because it might be illiquid.
Let’s explain with an example. Let us say that the total market capitalization of all companies is $1 trillion. The $50 billion company would have a 5% weight in this index by market-cap and the $100 million company would have a 0.01% weight in this index. If we created another index which reversed these weightings so that the $100 million company represented a 5% weight in this new index (let’s called it the ‘inverse index’ for now) and the $50 billion company had only a 0.01% weight in this index, this wouldn’t be a problem for the $50 billion company. But what if this index had $4 billion worth of investors’ money pouring into it on day one because they liked the concept. The index fund traders would have to allocate 5% of $4 billion into the $100 million company. 5% of $4 billion is $200 million. This would send the $100 million company’s stock soaring artificially. This is a problem of “index capacity”.
So in practice, this would not work.
This is essentially the same line of thinking which explains why an equal weighted index will not work as well in practice as it does in theory. An equal weighted S&P500 index would allocate a 0.2% weighting to each stock in the S&P500 index. Now, your exposure to pricing errors is randomized instead of the tendency to overweight overpriced stocks and underweight underpriced stocks. Maintaining a 0.2% weighting to each stock would have higher turnover than a regular cap-weighted index, but the same problem of capacity concerns on the smaller stocks exist as with the above example.
In the next part of this series we will look at how else we can randomize the exposure to pricing errors without these ancillary problems cropping up. (We can never eliminate pricing errors.)