Dr Christian Jasperneite, CIO, Private Asset Management, MM Warburg, fresh from his appearance at this year’s IMPower Fund Forum, writes that in the world of investing, few things are as taken for granted as the dominance of market-capitalisation-weighted indices.
Whether in ETFs or benchmark portfolios, most investors – institutional and retail alike – rely heavily on indices that allocate weight based on a company’s market cap. It’s a convenient, seemingly logical approach. And for years, it has paid off handsomely. Or so it seemed.
But in a world undergoing dramatic shifts, it’s time to question that logic. Market capitalisation reflects the past, not the future. And increasingly, this backward-looking measure is steering portfolios into dangerous territory.
The hidden flaws of market cap weighting
At first glance, weighting by market cap feels rational. Bigger companies get more weight, smaller companies less. But here’s the catch: market cap is nothing more than price times shares outstanding – a snapshot of past success, not a predictor of future performance.
For the last two decades, that backward-looking lens has favored global tech giants. Their dominance of the digital economy and global supply chains made them obvious winners. But now, cracks are appearing. In a world where globalisation is stalling, supply chains are localising, and authoritarian mercantilism is on the rise, past success is no longer a guarantee of future dominance. Even more alarming is the sheer concentration that has built up in major indices. In many, the top 10 per cent of stocks account for 40 per cent, 50 per cent, even 60 per cent of total index weight. In the US, the “Magnificent Seven” alone can drive the entire market. Calling this diversified is, frankly, misleading. When such concentrated portfolios begin to falter, investors in passive vehicles like ETFs bear the brunt. A regime shift is underway. And market-cap indices are ill-equipped to respond.
Equal weighting? Not quite the answer
Some investors have turned to equal-weighted indices as an antidote to concentration. Every stock gets the same weight, regardless of size. It sounds fair, democratic even. But it’s not without its problems.
First, equal weighting can massively overweight illiquid small-cap stocks, making the index hard to replicate at scale. Second, it deviates significantly from benchmark structures, creating risks for institutional investors tied to tracking error constraints. In other words, equal weighting introduces its own distortions.
The middle ground: Square root weighting
Is there a smarter, more balanced way? Yes – and it involves a surprisingly simple mathematical twist: weight stocks by the square root of their market capitalisation.
This approach preserves the intuitive hierarchy of market cap—large companies still get more weight—but reduces extreme concentration. It also avoids the liquidity issues of equal weighting. The result? Better diversification, less hidden risk, and greater resilience to structural change. Extensive backtests show that portfolios constructed using square-root weighting offer more stable risk-return characteristics. They produce fewer extreme outliers, tighter Sharpe ratio distributions, and lower volatility—especially in portfolios with 30 to 50 stocks. That’s a powerful outcome for both passive index investors and active stock pickers.
Why it matters for active managers too
Even active managers are not immune to the pitfalls of market-cap weighting. While they may carefully select stocks based on fundamentals or themes, many still fall back on market cap to determine position size. The logic is straightforward: big stocks are liquid, tracking error is reduced, and benchmarks are easier to match. But the cost is hidden concentration. In a 30-stock portfolio, three mega-cap names could easily make up 50 per cent of total exposure. If they share a sector or macro sensitivity, the whole portfolio becomes vulnerable to a single shock.
Square-root weighting offers a compelling fix. It anchors weight to company size—helping with liquidity and benchmark alignment—while dampening excessive exposure. It’s a way to express conviction without betting the house on a few giants.
Taking it one step further: Targeting concentration directly
Even square-root weighting has a degree of arbitrariness. Why the square root and not, say, the cube root? What if we could directly control concentration in the index, rather than accept it as a byproduct of weighting?
It turns out we can. By replacing the square root with a flexible nth root—where n is adjusted to meet a desired concentration level—we can target specific outcomes. Want to ensure that the top 10 per cent of stocks never exceed 30 per cent of index weight? Solve for n accordingly. In periods of rising concentration, n becomes smaller, reducing top-heavy exposure. In more equal markets, n increases slightly, giving leaders their due. This method introduces an elegant, rule-based way to implement counter-cyclical allocation: trimming overweights in bubbles, adding exposure in corrections—all without subjective judgment.
The future of index design
Since 2012, indices constructed using root-based or concentration-targeting methods have performed comparably to traditional indices in Europe and only marginally underperformed in the US. But the real story lies in recent months: while market-cap indices (for some time) faltered amid sectoral corrections, alternative constructions held their ground.
That’s not just historical trivia. It’s a glimpse into a future where resilience matters more than momentum, and where index design becomes a lever for managing real-world risk—not just following market fads.
Final thoughts
It’s time to move beyond the outdated orthodoxy of market-cap weighting. Yes, it worked in the past. But the past is not coming back. Concentration is a real, growing threat. And equal weighting, while appealing in theory, falls short in practice.
The smart path forward lies in thoughtful compression of weights—through the square root of market cap, or even better, through methods that directly manage concentration. These approaches preserve what matters—liquidity, structure, and economic logic—while curbing what hurts: excessive exposure to yesterday’s winners. In a world of upheaval and transition, smarter index construction isn’t a luxury. It’s a necessity.
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