An article in Morningstar discusses the downside of using market-cap-weighted indexes, noting that within certain markets or strategies this approach can “compromise diversification and intended factor exposure.”

“The assumption that market participants act rationally isn’t necessarily true,” the article argues, adding that history shows how euphoria can lead to a stock price becoming heated and deviating “wildly from its true underlying value.”  Owning a cap-weighted index, it argues, “could result in overweighting those stocks that have the richest valuations.”

In some markets, those assets with high market caps “may become so large that they wind up monopolizing the index,” the article says, which can compromise diversification.

“Assessing the geographic diversification of the benchmarks that underlie index funds and exchange-traded funds is a crucial element of our assessment of these funds’ processes, which in turn informs our Morningstar Analyst Ratings,” the article notes.

Companies with smaller relative market caps, the article asserts, “particularly firms that are of higher quality, have historically been associated with returns that beat a broad market index. But market-cap weighting, by definition, underweights these smaller companies and reduces their contribution to the overall index.”

Declining share prices, the article contends, provide important information for value investors and could reveal a good opportunity to buy. But when the market “turns sour” on a company’s outlook, a market-cap weighted strategy will then own less of that stock. “The contrarian nature of value investing,” the article says, “makes it incredibly difficult to be an effective value investor while using a cap-weighted strategy. The two just don’t work well together.”

The article concludes by suggesting that value investors apply strategies that use “alternative methods to weight their constituents.  Such methods, it says, provide a “range of opinions regarding each stock’s value that is necessary to the market’s collective wisdom.”

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