I find it interesting that most of the popular index funds are market-cap weighted, and that's just how it is. Why is it that way? Why do we think that owning the biggest companies should be the default?
1. You need some way of normalizing shares to produce a statistical sampling of the market, and capitalization is the obvious, existing market mechanism to do this.
2. You need to resist brute attacks on the index investment strategy. I.e. if a giant fund is known to just consider all shares equal, you could soak them by doing wild stock splits to put more of your shares on the market. Or if they consider all companies equal, you could soak them by bringing lots of empty shell companies to the market.
What is the market? The market is something like the returns of the S&P 500 index. How do we get the returns of the market? Make a fund that tracks the S&P 500 index. Why do we have funds that use market-cap weightings? Because we want to track the market.
I guess it's not about having an equal representation of companies or industries or sectors, it's about having an equal representation of where dollars are allocated. The goal isn't to take a dollar and buy a share of each company, the goal is to take a dollar and buy more of the companies that other people own more of and less of the ones they don't?
My point is market-cap weighted index funds are an investment strategy and not some neutral default thing that people seem to think they are (or maybe I'm projecting).
I think the point is there is no such thing as "neutral default". There has to be some weighing to define the market and distribution of your investments. Any act to prune the whole world economy into an actionable list is, in effect, a kind of weighing.
Existing indexes represent tried-and-true weighing methods that have are considered to summarize a market in some useful way. Index funds leverage that on purpose to not do a bunch of bespoke analysis. Not using one of these indexes puts you back in the realm of a managed fund with its own active research and forecasting...?
