I posted about this on r/bogleheads earlier, but I thought it might be better for discussion in this sub…
I’ve been exploring potential problems with some of the thinking surrounding global market cap weighted strategies. I generally like using market cap weights for simplicity and cost-effectiveness, but I can’t seem to shake this feeling that there might be something wrong with the fundamental operations of this strategy, specifically around two related parts: 1) Country weighting, when considering IPOs change a country’s market cap relative to other countries, and 2) the potentially unlimited number of companies that can theoretically be added to an index-based investment like VT, VTI, VXUS, etc.
I’m really trying to wrap my head around some of this, but I’m having a tough time doing so:
1) In my mind, it seems like using a country’s market cap to determine its weight in a global portfolio experiences problems when considering IPOs and adding new companies into that country’s total weight. Basically, an individual country’s stock market “growth” relative to other countries could be driven by an increase in the number (and size) of companies going public instead of actual underlying profit growth. When country A’s market cap increases relative to country B’s, driven by IPOs, you are forced to sell country B’s stocks to buy country A’s newly added companies. This feels like an inefficiency that exists simply because country A may have more companies going public, so its growth in the index isn’t driven by company performance, but rather by changes in the ratio of public and private companies. This seems like it could potentially be a major flaw in the logic of global market cap weight portfolios and means that an index ETF like VT is just subsidizing countries who have relatively more IPOs. Maybe this is somewhat fixed if you were able to break down your portfolio into smaller components, such as individual country ETFs, to contain the effect somewhat, but I really don’t know.
2) Related to the idea above, for a market cap weighted ETF like VT or VTI, which tries to capture the entire stock market (whether globally or of an individual country), there is theoretically no limit on the number of stocks that can be added to the index. Something feels off about this (when compared to an index with a target set number of holdings, like the S&P 1500) because of potential inefficiencies with the variable number of holdings in the index. If there were a limit of 1500 stocks that could be held, then you would generally sell one stock to buy another of approximately equal value when a new company was added through an IPO or minimum market cap limit being reached (both companies market caps being theoretically similar sizes (I know IPO additions don’t always have the same market caps as the company lies they are replacing). In VT, VTI, or VXUS, because you aren’t replacing holdings, you would need to sell a bit of all of your holdings to buy a company being added to the index. This seems like a weird thing to do, but I’m not sure if it is actually meaningful. In my head, it seems like having some limit on the number of holdings in an index helps the index be more efficient. Am I thinking about this correctly?
I’m hoping someone can point me towards any academic papers on these ideas. I’m not even sure if these are actual problems or just issues I’m inventing in my head?