If an index is weighted by market cap (market capitalisation – the number of shares outstanding multiplied by the share price), it means the companies in the index are ranked by stockmarket value. Most of the major global equity indices – though not all of them – are weighted in this way. So, for example, in the FTSE 100 index right now, oil major Royal Dutch Shell is the top stock, with a market cap of around £169bn, while right at the bottom is subprime lender Provident Financial, with a market cap of £3.5bn or so. In effect, as a stock becomes more popular – as its share price goes up – it rises in the index, and as it loses fans – its share price falls – it drops down the index.
In theory, this is a far from sensible way to invest in a market. If you passively track a market-cap-weighted index, then you are putting the majority of your money into the most popular stocks, and as a company becomes less popular you sell out of it. That’s the opposite of the “buy low, sell high” mantra. Also, it means your portfolio is far more heavily weighted to certain stocks and sectors than you might think. For example, a FTSE 350 tracker might give the impression that you own 350 stocks, but in practice, about 7.5% of your money will be in Shell alone, and nearly 40% of your money in the top ten stocks. So there are some reasonable objections to using a “vanilla” passive fund.
However, in practice, despite these flaws, market indices still beat the majority of actively managed funds. That means that you have to have a very good reason to opt for an active fund over a simple, cheap tracker or exchange-traded fund. If you do opt for an alternative, then make sure that before you buy in you understand exactly what the fund does, and why it claims to be able to deliver you a better return than the market itself.