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When to Use Market Cap Weighted ETFs

Investors that go against the natural market-cap-weighting process begin to stack the deck against themselves - but is the traditional approach always best?

The stock market is simply the sum of all transactions for shares of publicly listed companies, millions of which are conducted every day. Hour by hour, minute by minute, Benjamin Graham's voting machine is hard at work as market participants express their opinions regarding a company's future prospects through the price at which its shares transact. In a rational world, these opinions and the ensuing actions are based on an investor's knowledge and understanding of these firms. New information is combined with old, and prices fluctuate through a continuous auction-like process.

A company's share price that results from this system, when multiplied by total shares outstanding, forms its market capitalisation. Thus, as a company's share price appreciates, its market capitalisation and enterprise value grows, increasing in value relative to the overall market. With size comes benefits, including economies of scale, diversified revenue streams, and brand recognition. The winners of the competitive election process grow bigger and prosper, while the losers are relegated to the boneyard of capitalism.

Such a competitive process forms a simple basis for weighting stocks in an index. An index weighted by the market capitalisation of its constituents accurately reflects the market's opinion of each firm's value relative to its peers. The index is also self-balancing. The competitive pricing mechanism establishes a natural hierarchy that will alter a firm's weighting in proportion to its continuously changing capitalisation.

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About Author

Morningstar ETF Analysts  research hundreds of ETFs available to European investors. The Morningstar Rating for ETFs is based on a risk-adjusted performance measure

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