@jerry: Rob Arnott of Research Associates [Research Associates was referenced in the linked article] supports what you are saying to some extent. He has done a lot of research in this area, and he concludes that almost any way to construct an index has outperformed a capitalization weighted index. Part of it is what you said, the fact that you get an average lower cap of the stocks. Rob Arnott says that a big part of it is that a cap weighting overweights the most expensive stocks, the most overvalued ones [cap weighting=price X shares outstanding]. He also says that market cap weighting does not capture the economic footprint of a company. For example, although Apple is weighted the most heavily in a cap weighted index, iirc, Walmart has the most sales of any company in the U.S., which relates more to economic footprint. So he believes in weighting on more fundamental factors, such as [again, iirc] cash flow, dividends, etc, to weight by economic footprint rather than by market cap.
For Rob Arnott, the key thing is to NOT weight the portfolio by price, which is essentially what a market cap weighting is doing, as price x #shares. He says that by market weighting, you are pushing away value, and loading up on growth......favoring stocks that have higher valuations.
Here's an interview [with transcript if you prefer that] that adds to the discussion above:
http://www.morningstar.com/cover/videocenter.aspx?id=613699By the way, I don't own any of the fundamental index funds. My index funds are the standard ones, which are cap weighted, mostly Vanguard. I haven't made up my mind wrt the best indexes to invest in, e.g., fundamental index methodology, different forms of factor weighting/"smart beta", etc. A while back I took a look at the performance of the Schwab Fundamental Weighted indexes, and I was not overwhelmed.....certainly not enough to want to sell my traditional index funds, pay the capital gains taxes, and purchase other index funds with a different weighting methodology.
What is being talked about a lot these days is weighting an index by size (smaller), value, profitability, and more recently, momentum. The DFA 'index' funds are now factoring these into their weighting methodology.
@mjg: from the trivia department......correct me if I am wrong, but the S&P
500 Index currently has
501 stocks.
It's the Vanguard S&P
500 Index Fund that has
504 stocks, but that is different than the Standard & Poor's
500 Index. Note that the Schwab and Fidelity index fund versions also contain
501 stocks.
Standard & Poor's has a nice fact sheet on their index:
http://us.spindices.com/indices/equity/sp-500Finally, in the article which is the topic of this discussion, the author states that he is using a universe of the top 3000 stocks in the world, based on market value. So not the S&P
500.