Thread by @Jesse_Livermore

THREAD: Market-Cap Weighting under Policy Dominance (Fiscal nGDP Targeting)

The disadvantages of market-cap (mcap) weighting are well known. Here, I want to elaborate on a benefit that it might offer, which I mentioned in recent ILTB podcast. Small, but potentially interesting.

When you weight a portfolio by market capitalization, you end up owning roughly the same % of the outstanding shares of each company in the market. You end up with the same ownership "stake" in each.

This point is simple to prove mathematically, but the quickest way to see it is to just look at a popular mcap-weighted ETF--e.g., $SPY. (The example that best captures the overall point of the thread would be a total mkt ETF like $VTI, but $SPY suffices to make the current pt).

The table below shows $SPY's top holdings alongside $SPY's percent ownership of the total outstanding shares of each company. Notice that $SPY owns the same percentage of the outstanding shares of each company, roughly 1%.

The uniformity in overall ownership % is not a coincidence. It follows logically from the definition of mcap weighting.

Exceptions to it are driven primarily by $SPY's float-adjustment. $WMT, for example, is ~50% owned by the Walton family. $SPY owns a ~1% stake in the remaining ~50% that makes up the "float", so it owns a ~0.5% stake in the overall company, shown below.

So when u weight your portfolio by mcap, you end up mcap-weighted from a perspective inside *your* portfolio. But from a perspective inside the *companies*, you end up equal-weighted, in the sense that you end up with the same ownership stake in each company.

How might this be of benefit? Well, if u know the government is going to inject some lvl of spending into the economy through stimulus, but u don't know where it will end up, mcap weighting will tend to minimize your exposure to the risk factor of where it will end up.

Obviously, this point comes with the caveat that not all spending in an economy gets spent into corporations, and not all corporations in an economy are publicly-traded. Goes without saying.

But for spending that does go into publicly-traded corporations, mcap weighting minimizes the sensitivity of the portfolio's revenue to the arrival point of the spending. The portfolio's revenue ends up being the same regardless of which companies the money gets spent into.

To see this point, just assume that you own 100% of every business in the economy. If overall spending into businesses will increase by some amount $X, will the composition of the increase make a difference to your overall revenue? No. You'll receive 100% of it wherever it goes.

The same holds true if you own a smaller percentage of each company--e.g., 10%, 1%, 0.000001% , etc. You'll receive that percentage of the incoming revenue regardless of where the spending goes.

Additional caveat: revenue is obviously not profit. Your portfolio's *earnings* will therefore remain exposed to variance in the profitability of the companies that the money might get spent into. Goes without saying.

Now, it's intuitively temping to think that a different type of weighting, such as a fundamental weighting, would do a better job of minimizing the sensitivity of the portfolio's revenue to the destination of the spending.

An example can help clarify why that's not the case. Suppose that you know that $100B of new stimulus spending is ultimately headed into the publicly-traded corporate sector. But you don't know which companies will receive it as revenue, or how much they'll each receive.

That's a key assumption btw--that you don't have any information at all on where the money will be spent. If you do have information relevant to that consideration, then obviously you don't want to mcap weight. You want to buy the receivers of the revenue.

But let's say you weight the portfolio fundamentally on *revenue*, meaning that you allocate to each company based on its share of overall (trailing) revenue. The money then ends up being spent into a single company w/ no revenue at all--e.g., some early stage biotech.

In that case, your portfolio will receive *none* of the spent money as revenue. You won't have any position in the company at all, b/c its share of overall (trailing) revenue is zero.

At the other extreme, suppose that all the money is spent into a single cheaply-priced company w/ high revenue share--say, Exxon. In comparison w/ other companies, you'll own a relatively large % of overall Exxon, so your portfolio will benefit from the money being spent there.

To summarize, in this fundamentally-weighted scheme, you will do well, receiving a lot of the stimulus spending, if it gets spent into Exxon, and poorly, receiving none of it, if it gets spent into the biotech. The associated risk factor will not have been minimized.

But what if u weighted by mcap? Well, you'd then own the same % stake in the O/S shares of each company. If u specifically owned, say, 0.000001% of each company's shares, then no matter where the spending went, you'd receive 0.000001% of it into your portfolio as revenue.

If the money were spent into the pre-revenue biotech, you would own 0.000001% of that Biotech, and therefore your portfolio would receive 0.000001% of the money. Same if the money went into Exxon. You would own 0.000001% of Exxon, and would receive 0.000001% of the money.

Regardless of where in the publicly-traded corporate sector the $100B gets spent, if u are *truly* mcap-weighted, your portfolio is going to receive the same revenue from it. In the current case, your portfolio is going to receive: 0.000001% * $100B = $100,000.

Looking from inside your portfolio, it might receive the $100K in the form of a small allocation to a biotech whose sales per share explodes when $100B gets spent into it, or a large allocation to giant Exxon whose sales per share increases much less upon receiving that amt.

Either way, with $100B of injected spending and a true mcap allocation that maps to a 0.000001% stake in each company, $100,000 will come into your portfolio as revenue from the spending, no matter where in the publicly-traded corporate sector the $100B gets spent.

This feature may become relevant to future world where government uses fiscal policy to target nominal growth. Unlike monetary, fiscal policy can achieve any nominal outcome it wants. Can potentially eliminate nominal economy-wide revenue growth as a significant risk factor.

By minimizing the deviations of a portfolio's revenue from economy-wide revenue, you would then minimize the variance of the portfolio's revenue growth more generally, since the economy's revenue growth would be locked on the target. Albeit w/ the earlier caveats.

This same point can be made using other framings and in totally unrelated contexts, but I was focusing on it as it might apply to a credible nominal-growth-targeting policy regime, which we're moving towards and may one day enter into.

Are mkts efficient? If so, there's no cost to minimizing the sensitivity. If not, if companies can be overval'd/underval'd, cost will be your exposure to them, which will tend to increase/decrease as they become more overval'd/underval'd, the opposite of what u should want. /END