Latest / How Canadian Markets Work / Episode 58: Indexes (The Weighting Game)

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Episode 58: Indexes (The Weighting Game) · How Canadian Markets Work

0:00
I want you to imagine looking at your screen
0:02
at the end of the trading day, and you check
0:05
the headline, and it says, the index closed up
0:08
2 .5%. Which, I mean, by any standard, that is
0:11
a remarkably strong day in the market. Right,
0:14
exactly. But then you look closer at your own
0:16
portfolio. You look at the actual companies that
0:20
make up that index, and you realize that four
0:22
out of the five largest companies in that very
0:25
same index actually fell. Like, they shrank.
0:28
Wow. Yeah. 80 % of the businesses lost money,
0:31
yet the headline number flashed this brilliant
0:35
green. It sounds like a statistical mirage. Yeah.
0:40
Right. Or a flaw in the data feed. Yeah. But
0:42
this scenario actually plays out constantly just
0:45
in broad daylight across almost every major financial
0:48
market in the world. Well, welcome to today's
0:50
Deep Dive. We are taking our time today to really
0:53
look under the hood of something we hear about
0:55
every single day on the news, which is... The
0:57
index. Our sources today consist of this. of
1:02
financial educational materials and technical
1:04
manuals. They detail the actual mechanical plumbing
1:08
of financial markets. Which is fascinating stuff.
1:11
It really is. And our mission for this deep dive
1:14
is to deconstruct that headline number we all
1:16
take for granted. We're going to explore how
1:18
indexes are built, why their movements so frequently
1:22
contradict the reality of your own diversified
1:24
portfolio, and why the number you see quoted
1:27
on the evening news is, well, it's secretly missing
1:30
the majority of... the actual wealth generated
1:32
by the market. Yeah, we tend to treat terms like
1:34
the market and the index as perfectly interchangeable
1:38
synonyms. Right. We assume the index is this
1:41
thermometer taking the temperature of the entire
1:43
economy. But an index is really just a measuring
1:45
tool. OK. And it has highly specific hard -coded
1:49
biases. So to understand how the tool behaves,
1:52
you kind of have to look at the blueprints of
1:53
how it was built. Right. So to solve the riddle
1:56
from our opening the scenario where 80 % of the
1:59
companies fall, but the index still rises. We
2:02
first have to understand how an index decides
2:06
who matters. Because we're conditioned to think
2:09
of a market index like a democracy. One stock,
2:13
one vote. But looking at the architecture described
2:16
in our sources, these broad market indexes are
2:19
capitalization weighted. So a company influence
2:22
on the index is strictly proportional to its
2:24
market value. Which fundamentally alters the
2:27
power dynamic. I mean market capitalization is
2:29
simply the current share price multiplied by
2:31
the total number of shares outstanding. Okay.
2:34
So if you have an index of a hundred companies
2:36
they do not all get an equal say. in which direction
2:39
the index moves today. The larger the market
2:42
cap, the heavier the gravitational pull that
2:44
company exerts on the entire index. So the most
2:47
fitting analogy here is probably a corporate
2:49
boardroom where voting power is allocated by
2:52
wealth rather than headcount. Oh, that's a great
2:55
way to put it. Yeah, it's $1, one vote. So a
2:58
company worth $100 billion is going to move the
3:01
index 20 times more than a company worth $5 billion.
3:05
Exactly. The sheer mass of the giants just dictates
3:08
the direction of the ship, regardless of what
3:11
the smaller passengers are doing. Right. And
3:12
that capitalization weighted structure creates
3:15
this fascinating momentum effect. How so? Well,
3:19
as a company's stock price goes up, its market
3:22
capitalization grows, which means it occupies
3:25
a larger percentage of the index, which gives
3:27
it even more influence over the index's daily
3:29
movements. There is a crucial modifier to this
3:33
rule that we have to introduce here. Okay, and
3:36
that is float adjustment, right? I noticed that
3:38
term repeating throughout the technical documentation
3:41
the sources specify float adjusted market capitalization
3:45
So if market cap is just share price multiplied
3:48
by total shares the float adjustment implies
3:51
that not all shares are treated equally by the
3:54
index provider That's right. It seems to suggest
3:56
that If a massive block of shares is held by
4:00
a founder or a government, and it never actually
4:03
trades on the open market, those shares are entirely
4:05
excluded from the math. Is that right? That is
4:07
the precise mechanism. Yeah. Float adjustment
4:10
isolates the, well, the tradable reality of the
4:14
market. OK. So if a founding family owns 60 %
4:17
of a massive corporation and keeps those shares
4:19
locked in a vault, those shares are practically
4:22
invisible to you and me. We can't buy them. Right,
4:24
they're off the table. Exactly. Right. Therefore,
4:27
the index provider argues that those shares shouldn't
4:30
count toward the company's weight in the index.
4:33
The float -adjusted cap only counts the shares
4:35
that are genuinely floating in the public arena,
4:37
you know, available for everyday investors to
4:40
trade. I mean, that makes logical sense, but
4:41
it also means the index isn't actually measuring
4:44
the true size of these companies. It's measuring
4:46
the size of their available public liquidity.
4:49
So in markets with heavy institutional or family
4:52
ownership, that adjustment must radically alter
4:55
the hierarchy of the index. Well, it reshapes
4:58
the landscape entirely. The Canadian market...
5:01
measured by the S &P TSX composite serves as
5:05
a prime example of this in our sources. Oh, interesting.
5:07
Yeah, the Canadian corporate landscape features
5:09
a significant number of very large companies
5:12
with controlling shareholders. You have legacy
5:15
founding families. You have dual class share
5:17
structures where a small group holds voting control.
5:19
Right. And you have massive institutional blocks.
5:23
So when you apply the float adjustment. to the
5:25
TSES composite, the weight of those specific
5:28
companies drops substantially compared to their
5:31
raw size on paper. Wow. Because power in the
5:35
index is based purely on tradable size. Yes.
5:37
So this creates a highly concentrated environment.
5:40
The index is basically reduced to tracking the
5:42
largest blogs of available capital. Exactly.
5:45
And in a market like Canada, that concentrates
5:47
power into just a few dominant sectors, right?
5:50
Financials, energy, and materials. Yep. The banks,
5:53
the pipelines, and the mines just hold a disproportionate
5:56
amount of the voting power. And that concentration
5:58
is the direct cause of the mathematical mirage
6:01
we open with. The riddle. Right. Because power
6:04
is so heavily concentrated at the very top, the
6:07
daily performance of the index is effectively
6:09
decoupled from the performance of the average
6:11
constituent company. Let's dissect the mechanics
6:14
of that illusion, because looking at the five
6:15
company model in the source material, the disparity
6:18
between the headline and the underlying reality
6:21
is staggering. It really is. So let's walk through
6:25
it slowly. Imagine a simplified fictional index
6:28
with a total float adjusted value of $200 billion,
6:32
and it contains just five companies. OK, so we
6:36
can assign the weights to mirror a top heavy
6:38
concentrated market. Right. Company A is the
6:41
undisputed giant. It's valued at $100 billion
6:43
on its own, making it exactly 50 % of the entire
6:47
index. And the other four companies share the
6:49
remaining half. Right. So company B is $60 billion.
6:53
Company C is $25 billion. Company D is $10 billion,
6:57
and Company E is a relatively tiny $5 billion.
7:00
So when the trading day begins, Company A, our
7:03
giant, has a remarkably strong day. Its stock
7:06
price surges by 10%. Meanwhile, the broader economy
7:09
is struggling. Every other company in the index,
7:12
companies B, C, D, and E, has a poor day. They
7:15
each fall by 5%. So when you calculate the net
7:18
change of the entire $200 billion pool, the massive
7:23
gains from company A entirely swallowed the combined
7:27
losses of the four smaller companies. The net
7:30
result for the total index is a gain of 2 .5%.
7:34
And then the evening news flashes green. Right.
7:37
The anchor announces that the market surged today,
7:40
but any investor holding a diversified portfolio
7:43
of those businesses is experiencing a completely
7:46
different reality. Yeah, because if an investor
7:48
decided to bypass the cap weighted index and
7:51
instead built an equal weight portfolio, putting
7:54
20 % of their capital into it. Exactly. Putting
7:56
20 % into each of the five companies, their daily
7:58
return is profoundly different. So different.
8:01
Averaging the 10 % gain of the giant against
8:04
the 5 % losses of the other four positions results
8:07
in a net loss of 2 % for the day. The cap weighted
8:10
index is up two and a half percent while the
8:13
equal weight portfolio is down two percent. I
8:15
mean that is a massive four and a half point
8:17
chasm in performance on the exact same day holding
8:21
the exact same companies. It's incredible. And
8:24
this divergence is a persistent source of confusion
8:28
for everyday investors. I can imagine. You know
8:31
you might hold a broadly diversified personal
8:34
account spanning technology, health care, consumer
8:37
goods, and financial services. And you watch
8:40
the headline index surge upward, propelled by
8:43
a handful of mega cap stocks in a specific sector.
8:46
And you look at your own declining balance, assuming
8:48
you've made a terrible mistake. But you haven't
8:50
made a mistake. No. You're simply comparing an
8:53
equal weight diversified reality against a cap
8:55
weighted concentrated measuring tool. Exactly.
8:58
The index is not a reflection of the average
9:01
company's health. It's a reflection of the largest
9:03
company's health. And that concentrated power
9:06
dynamic really forces us to look at the gatekeepers.
9:08
Oh, for sure. Because if a company's sheer size
9:11
gives it the mathematical leverage to single
9:14
-handedly drag the index upward or downward,
9:18
you would assume the criteria for entering that
9:20
index are incredibly rigorous. Well, that is
9:22
the assumption most investors make. We assume
9:25
inclusion in a prestigious benchmark index acts
9:28
as a seal of approval from the financial establishment.
9:31
Like they're looking at the balance sheets and
9:33
making sure it's a good business. Right. But
9:35
digging into the rule books published by the
9:37
index committees in our sources, there is a glaring
9:40
absence of qualitative vetting. Wait, really?
9:43
Yeah. There's no strict profitability requirement,
9:46
no assessment of the management team's competence,
9:49
no deep dive into the company's debt to equity
9:52
ratio. That's why. The committee is not acting
9:54
in the capacity of an investment analyst. They
9:57
are administrators applying a mechanical formula.
10:00
OK. Index membership is determined almost entirely
10:03
by two metrics, minimum float adjusted market
10:05
capitalization and minimum trading liquidity.
10:08
So they're simply asking if the company has grown
10:10
large enough and if its shares change hands frequently
10:13
enough to meet the rulebook's threshold. That's
10:16
it. Which honestly reveals a fascinating structural
10:20
vulnerability in the system. How so? Well...
10:23
A company could be burning through cash, carrying
10:25
dangerous levels of leverage and riding a wave
10:28
of speculative temporary hype. Right. But if
10:32
that hype inflates at stock price enough to cross
10:34
the capitalization threshold and traders are
10:37
flipping the stock rapidly enough to meet the
10:40
liquidity threshold, the committee adds it to
10:42
the index. Yeah. It is a measure of popularity
10:45
and size, not a measure of business quality.
10:47
And the moment that company is added to the index,
10:50
it triggers a chain reaction that fundamentally
10:53
alters its valuation, entirely divorced from
10:56
its underlying fundamentals. Oh, the forced buying.
10:58
Exactly. This is the phenomenon of forced buying.
11:01
Because there are trillions of dollars parked
11:03
in passive index funds, and the sole mandate
11:05
of an index fund is to perfectly replicate the
11:08
holdings of the index. They have zero discretion.
11:11
None whatsoever. When the committee announces
11:14
a new addition, every index fund tracking that
11:17
benchmark is mechanically obligated to buy shares
11:20
of that company just to match its new weight
11:22
in the index. It does not matter if the portfolio
11:26
managers at those funds believe the stock is
11:28
in a massive speculative bubble. Or if they think
11:31
the business model is destined to fail. Right.
11:33
The rule book dictates the purchase. It's an
11:36
automatic feedback loop. Market hype inflates
11:39
the price, which pushes the company over the
11:42
size threshold for index inclusion, which then
11:44
forces passive funds to blindly buy billions
11:48
of dollars of the stock, which drives the price
11:50
up even further. Completely mechanical. So being
11:52
in the index simply means you became massive
11:55
and liquid. It offers absolutely no guarantee
11:58
that you are a durable, high quality investment.
12:00
Exactly. So we've established that the index
12:03
is a mechanical list, heavily biased toward a
12:06
few massive players, agnostic to actual business
12:09
quality. Right. But our sources reveal another
12:11
layer of distortion. And this one involves how
12:14
we measure the performance of that list over
12:16
time. Oh, this is the missing money part. Yes.
12:18
Because the headline number we see quoted on
12:22
the financial networks, the one that tracks the
12:24
daily highs and lows, is routinely missing a
12:28
substantial piece of the total return. It is.
12:30
The source is distinguished between two completely
12:33
different calculations of the same index. You
12:36
have the price return index and the total return
12:38
index. And the media... almost exclusively relies
12:42
on the price return index. This calculation tracks
12:45
only the capital appreciation, so just the changes
12:48
in the share prices of the constituent companies.
12:51
If a stock moves from $10 to $11, the index captures
12:55
that $1 gain and nothing else. Which completely
12:59
ignores the cash that those companies pay out
13:01
to their shareholders. It ignores the dividends.
13:03
Exactly. The total return index, on the other
13:05
hand, tracks the price changes, but also includes
13:08
all the dividends paid out, operating under the
13:10
assumption that those dividends are immediately
13:12
reinvested back into the index. And the media
13:15
utilizes the price return index because it's
13:17
simple, it's clean, and it can be calculated
13:20
pick by tick in real time throughout the trading
13:23
day. Right. Calculating reinvested dividends
13:25
is a more complex end of day mathematical operation.
13:27
but prioritizing that real -time speed over total
13:31
accuracy creates a massive compounding gap over
13:36
long time horizons. I mean I want to push back
13:38
on that a little because a dividend yield of
13:41
two or three percent a year might seem like a
13:43
rounding error when you're looking at a daily
13:45
chart. Does leaving them out really distort the
13:47
picture that much? It really does because the
13:50
math of compounding turns that rounding error
13:52
into the dominant driver of wealth. Okay let's
13:55
hear the math. So, if we look at a historical
13:57
analogy, investing $10 ,000 in a broad market
14:00
index 30 years ago and tracking only the price
14:03
return might show your portfolio growing to roughly
14:06
$40 ,000 today. OK, which looks like a solid
14:09
quadruple of your money. Not bad. Not bad, but
14:12
that is a fractured picture. An actual investor
14:14
holding those shares would have collected those
14:16
quarterly dividends and reinvested them. Buying
14:19
fractional shares. Right. Which then produce
14:21
their own dividends, accelerating the compounding
14:24
curve. So tracking the total return of that same
14:27
$10 ,000 over the same 30 years yields a figure
14:32
well over $100 ,000. Oh, wow. So the headline
14:35
number is essentially hiding more than half of
14:38
the actual wealth generated by the market. Yes.
14:41
The price return index treats those billions
14:43
of dollars in dividends as if they evaporated
14:46
into thin air. And this distinction isn't just
14:50
academic. It has profound implications for how
14:53
everyday learners evaluate their own financial
14:55
progress. Yeah, because when the end of the year
14:58
arrives, investors naturally want to benchmark
15:01
their personal portfolio's performance against
15:03
the market. Right, to see if their strategy is
15:05
working. Exactly. So if you calculate your personal
15:08
gains, which naturally include the dividends
15:10
you've received and reinvested, and you compare
15:13
that total figure against the price return index
15:15
you see on the news, you're making a fundamental
15:18
error in logic. total return against the market's
15:22
partial return. You are artificially flattering
15:25
your own performance. Yep. An investor might
15:27
look at that flawed comparison and conclude they
15:30
possess exceptional stock picking skills because
15:32
they beat the headline index by 2%. Right. But
15:36
in reality, they simply fail to account for the
15:38
market's dividends. Yeah. If they compare their
15:41
portfolio against the proper total return benchmark,
15:44
they might discover they actually underperformed
15:47
the passive index. So the takeaway here is you
15:49
must compare total return to total return. Always.
15:53
Using the media's price return as your benchmark
15:55
is just a fast track to false confidence and
15:57
bad math. It's a subtle distortion, but once
16:00
you understand the mechanics of compounding,
16:02
you realize how broken the standard media narrative
16:05
actually is. It really highlights that the index
16:07
is not a neutral, infallible oracle of economic
16:11
truth. It is a highly specific tool. Which is
16:14
really the three line of all this. We've deconstructed
16:16
the capitalization waiting, revealing how a few
16:19
massive, float -adjusted giants dictate the trajectory
16:22
of the entire market. Creating those mathematical
16:25
mirages where the index rises while the majority
16:28
of businesses fall? We've examined the inclusion
16:31
criteria, exposing how index membership is a
16:34
function of pure size and liquidity rather than
16:37
fundamental business quality. Right. And we've
16:40
uncovered the compounding gap between price return
16:42
and total return, showing how the headline number
16:45
obscures the true generation of wealth. And understanding
16:48
these biases fundamentally shifts how you consume
16:51
financial information. Completely. But there
16:53
is a final concept documented in our sources
16:55
that builds on everything we've discussed today.
16:58
It exposes a structural vulnerability at the
17:01
very heart of passive investing. Oh, this circles
17:03
back to the mechanical rules -based nature of
17:06
the index. Exactly. We view indexes as abstract
17:08
concepts, but they are actual commercial products.
17:11
Right. The S &P 500, the TSX composite, these
17:14
are proprietary lists owned by index providers
17:17
who license them out for hefty fees to the mutual
17:20
funds and ETF providers. And because those funds
17:22
pay for the license, they are contractually bound
17:25
to track the index with absolute precision. Like
17:28
we mentioned earlier with the forced buying effect
17:30
when a new company is added. Right. But what
17:33
makes this mechanism vulnerable? is that the
17:36
rules for inclusion and the exact calendar dates
17:39
when those changes will occur are completely
17:41
public. Ah, of course. The index committee announces
17:44
their decisions well in advance. They do. They
17:47
publish a press release stating that, you know,
17:49
on the final Friday of the month at the market
17:51
close, Company X will be officially added to
17:54
the index and Company Y will be removed. So that
17:57
transparency is a feature of passive investing,
17:59
but it's also an arbitrager's dream. Oh, big
18:02
time. Because the active traders and market,
18:05
the hedge funds and high -frequency trading firms
18:07
can read the exact same rest release. If you
18:09
can. They know with absolute certainty that on
18:12
that specific Friday, trillions of dollars of
18:16
passive index money will be mathematically forced
18:19
to buy millions of shares of Company X, regardless
18:21
of the price. So the active traders simply step
18:24
in and buy the stock on Wednesday. Right. They
18:27
accumulate a massive position, driving the price
18:29
up in the days leading to the inclusion event.
18:32
And then when Friday arrives and the passive
18:34
funds are blindly forced to buy at the closing
18:37
bell, the active traders sell their accumulated
18:39
shares to the index funds at a premium. Wow.
18:43
They were legally front running the mechanical
18:45
trades of the passive investors. They are. It's
18:47
a documented structural cost of indexing. We're
18:50
consistently taught that passive investing is
18:52
the most efficient, low cost way to participate
18:55
in the market. Yeah. And while it remains highly
18:57
effective, it is not a perfectly sealed system.
19:01
the predictable, rigid mechanics of the index
19:04
create built -in leaks. The passive investors
19:07
are quietly paying a hidden toll. The very transparency
19:11
and rules -based architecture that make the index
19:14
passive are the exact features that allow active
19:17
traders to exploit it. The indexers absorb the
19:20
cost of that premium every single time the index
19:22
rebalances or updates its constituents. It demonstrates
19:25
that even the most passive investment strategy
19:27
is operating within a fiercely active ecosystem.
19:31
Right. The mechanics always carry a cost and
19:33
the market always finds a way to price in predictability.
19:36
Which brings us full circle to the screen at
19:38
the end of the trading day. The next time you
19:41
see the news anchor point to a chart and declare
19:43
the market as daily performance, you have the
19:46
tools to look past the superficial number. You
19:48
do. You know, you're looking at a cap weighted,
19:51
float adjusted. Dividend excluding commercially
19:54
licensed slice of the market where the absolute
19:57
largest blocks of capital steer the ship and
20:00
where active traders are constantly skimming
20:02
premiums off the mechanical rules. The headline
20:04
is an engineered output and understanding the
20:08
engineering is what separates the casual observer
20:10
from the informed investor. Well said. Thank
20:13
you for taking this deep dive into the architecture
20:16
of the index with us today. Keep questioning
20:19
the mechanics behind the numbers you see, and
20:21
we will see you on the next one.