If you are convinced that index investing is the way to go, you need to choose the indexes you want to invest in. You can create a portfolio that contains several indexes in which you are going to invest.
We have already talked about index investing and the way indexes were replicated. But we have not looked into details how to compare stock market indexes. There are a lot of stock market indexes. In fact, there are now more indexes than stocks. So index picking may become as difficult as stock picking. There are some very special stock market indexes. In this post, we are only going to focus on broad market indexes.
I am not going to go into details into exactly the portfolio you can choose. The post is really about choosing between different indexes. For instance, what is the difference between small indexes and large indexes? Or should you choose a market-cap weighted index or an equal-weighted index? If you already know you want to invest in U.S. equities, how do you choose between all the U.S. indexes?
This post should help you choose between indexes to invest into. There are many different indexes, even for the same country.
Country of the companies
I believe that the first step in choosing between different indexes is to decide into which country you want to invest in. Each index is generally about a country or a region of the world. There are even indexes that cover the entire world.
It is likely that you want to invest in your own country specifically. This is something that is known as an home-bias. Or maybe you want to invest in the country you plan to retire in. There are indexes for each country I know. I do not think you will have an issue finding an index for your country.
However, you probably also want to invest in international equities. There are indexes that cover the world but a single country. For instance, if you live in the United States, you could invest in the FTSE All-World Ex-US index that covers the entire world stocks but not the United States. Or you could invest directly in the Total World Index. This will cover the entire world. But you have to know that about half of it is United States stocks.
This step is entirely dependent on your situation. For large countries, you may even skip the international equities. For very small countries, you want more international allocation. And it will depend if you plan to retire in another country as well.
Size of the index
We often say that size does not matter, but this may not be true for indexes!
Now that you decided on the country or region you want to invest into, you will probably find that there are many indexes covering the same region. One big difference between these indexes is the size of the index. Most indexes are on a subset of the country (or region) companies.
For instance, here are some of the United States stock market indexes:
- Dow Jones Industrial Average (DJIA): 30 companies
- Standard & Poor’s 500 (S&P500): 500 companies
- Russell 3000 Index: 3000 companies
- U.S. Total Stock Market: About 3500 companies
As you can see, there are some very large differences in size between indexes. Some are very small (DJIA) and some are very large (Total Stock Market Index).
So what should you choose? Small indexes will only index very large companies. That means that you will only invest in large capitalization companies. But there are a lot of small and medium companies in the stock market. If you really want to replicate the performance of the market of the region you have chosen, you should choose a large index. The more companies there are in the index, the closer the index will be to replicate the market. For instance, over the years, there have been significant differences between the Dow Jones and the S&P 500 index.
On the other hand, at some point, you do not really need to add more companies. For instance, over time, there has little to no difference between the Total Stock Market index and Russell 3000. And even between S&P500 and Total Stock Market, the differences are not great.
Overall, I believe that large indexes are superior to small indexes. If you believe in indexing, you should try to replicate the market performance as closely as possible.
Size of the companies
Once again, I have to continue talking about size! Some indexes decide to only track some subset of the companies based on their size. Generally, the used metric for the size of a company is its market capitalization (market cap). This is the value of all the shares of the company at the current share price.
Generally, you will see three categories of companies:
- Large Cap: Companies that are worth at least 10 billion dollars.
- Medium Cap: Companies that are worth between 2 and 10 billion dollars.
- Small Cap: Companies that are worth less than 2 billion dollars.
Now, these are the rules for the U.S. companies. Generally, the same rules are being used in most stock market indexes. But each index is free to use different rules. For instance, Small Cap companies in Switzerland are generally described as companies that are worth less than one billion dollars (not two).
These are the most common categories. But sometimes, you will also see the Mega Cap name for companies worth more than 200 billion dollars, sometimes described with 300 billion dollars. And you may also Nano-Cap for companies below 50 million dollars and Micro-Cap for companies between 50 and 300 million dollars.
Now, the exact definition of these rules is not really important. What is important is that companies with different market cap can evolve differently in the stock market. Generally speaking, small-cap may generate more returns but have much greater volatility than large-cap companies.
For large stock market countries, such as the U.S. stock market, you are likely to find indexes for every size of market-cap companies. You may even find funds that invest in several of these categories such as small and mid-cap.
Personally, I do not like to invest in a specific market-cap segment. This is exactly like stock market picking or market timing and I do not think it will work in the long-term. However, if you feel like doing, you need to do your research and invest in something you really understand before you do it.
Style of investing
We just saw that we can categorize companies based on their size. Another way of categorizing companies is based on the style of investing. There are two main investing styles in which indexes are based:
- Value: Value investing consists in choosing companies for which the stock value is lower to the book value of the company. That means that we are trying to look for deals in the stock market.
- Growth: Growth Investing is almost the contrary to Value Investing. We are trying to find companies where the stock value outperformed the book value. The idea is that these companies are growing fast and will continue to grow.
In practice, it can be a bit more complicated than that. Indeed, it is likely that other things are taken into account when deciding on the style. For instance, many indexes are taking forecasted earnings into account. Another thing that is interesting is that some index providers are sometimes considering a company as both Growth and Value. That means that the same company could be both in the Growth version of the index and in the Value version. On the other hand, some companies are being stricter with that.
The weighting of the companies
Once an index decides on which companies it wants to include, it remains to be decided the weight of each company. For instance, Apple could be 10% of the index and Microsoft 8% and then a small company like Mattel could have a weight of 0.02%. Of course, indexes do not generally set the weights by hand. There are three main ways of weighting the companies in an index:
- Market-Capitalization Weighted Index: This is, by far, the most common type of index. In that case, each company has a weight based on its market capitalization and the entire market capitalization of the index. For instance, if an index has a sum of 500 millions of market capitalization and a company has a market capitalization of 10 million, this company will be 2% of the index. The bigger the company is and the bigger is its allocation. Sometimes, they are also called Value-Weighted indexes.
- Equal-Weighted Index. There are not that many indexes that are equal-weighted. The weight of each company in such an index is the same. If there are 20 companies in the index, they each will have 5% of the allocation. These are also sometimes called unweighted indexes.
- Price-Weighted: This is the rarest of the index type. In that case, each stock is weighted based on its share price. The number of shares does not play any role in the weights. If a company has a share price of 1000 and the sum of the share prices in the index is 25000, the weight of the company will be 4%. The most famous index is the Dow Jones Industrial Average (DJIA). The big problem with this kind of index is that company with very expensive shares are totally skewing the index. Berkshire Hataway, the company of Warren Buffett, has a share price of more than 100’000 dollars. Therefore, you cannot include it in any such index. Indeed, it would take a too large allocation.
Personally, I do not like price-weighted indexes, they do not make sense. As for the other two, there are advantages and disadvantages to each of them.
Market-capitalization weighted indexes are forming a much better representation of the market. This is logical since the value of the market is pushed more by the big companies than by the smaller ones. On the other hand, if the index has a lot of companies, the smaller companies may form an almost insignificant part of the index. For instance, in an index with only 500 companies, the smallest companies have less than 0.02% allocation. This is really small and may not make a big difference in the market value. Therefore, it does not make much sense to use more companies when the index is market capitalization weighted. Mega companies are overweight in the index. This is also an advantage since bigger companies tend to be more stable.
Equal-weighted indexes do not form an adequate representation of the market. Moreover, they can have a larger turnover rate, leading to higher management fees. Generally speaking, funds and ETFs of equal-weighted indexes are more expensive than the market-capitalization equivalents. On the other hand, these indexes are giving a much higher weight to smaller companies. And smaller companies generally outperform larger companies on the long-term. However, they have larger volatility. For instance, over the long-term, an equal-weighted S&P 500 index has generally outperformed the market-capitalization weighted version of the index.
Personally, I am still more in favor of market-capitalization weighted index. They are a good representation of the market. However, the problem is that they do not exhibit a good representation of small and medium companies. I believe it makes sense to invest in an equal-weighted index as well but probably not for the entire portfolio.
As you can see, picking an index is a difficult task. To keep it simple, I would recommend sticking with very broad indexes that integrate as many companies as possible into it. That way, you are will replicate the performance of the market itself.
If you start picking small and very specific indexes, you are market timing. If you only invest in small-cap companies in hope of greater returns, you need to be prepared to have to wait a very long time before they outperform large-cap companies. Market timing is difficult, if not impossible. Therefore, you should bet on the entire market indexes, not on too narrow indexes. Personally, I have chosen a few stock market indexes in my portfolio.
Even though you may not want to invest in specific indexes and keep with broad indexes, I believe it is still interesting to know about all the indexes our there. Knowledge about investing is very important!
Now that you know how to choose an index, learn how to choose an index fund to invest in an index.
What about you? How do you choose between indexes?