Let's use the S&P 500 as a model for a capitalization-weighted index.
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The S&P 500 index was developed in the late 1950s. It superseded an earlier S&P index that had 90 stocks.
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The change was made possible because of an increase in the computing power at the New York Stock Exchange (NYSE) and the American Stock Exchange (ASE). In the late 1950s, the NYSE and ASE computers became capable of tracking an index composed of 500 stocks throughout the day. The reason these computers could do this was because the index was capitalization-weighted: All the computers had to do was multiple the total outstanding shares for each stock by their current prices, sum the results, then divide that result by a divisor. Even the old IBM 360s that were prevalent at the time could do that as rapidly as the human operators could update the punch cards.
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And so the capitalization-weighted index became a standard for indexing.
In the early 1970s Wells Fargo created a pool of stocks based on the S&P 500 index. Wells Fargo offered the pool (kind of like today's mutual funds) to institutional investors. Because the Wells Fargo pool was S&P 500 index based, it gave institutional investors an easy way to meet the "prudent man" and "legal list" criteria (and laws) of the time at a minimal cost. This further solidified capitalization-weighted indexing.
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Jack Bogle picked up on Wells Fargo’s idea, and sold the concept to the general public. That planted the idea of capitalization-weighted indexing in the minds of average citizens/investors.
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Consider that, during the entire time that capitalization-weighted indexing has been sold as the “best” possible investment medium for both institutional and individual investors, all reputable business and finance schools have been teaching that another criteria actually determines the value (and ultimately the price) of stocks and other assets.
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Starting with Graham & Dodd's Security Analysis in 1934, and James C. Bonbright's The Valuation of Property in 1937, every single reputable business and finance school has been teaching that free cash flow (i.e., ability of a business -- or any asset -- to provide a dividend or return to the owners) is what determines the value (and ultimately the price) of an asset.
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Capitalization-weighted indexing and fundamental indexing are mutually exclusive: Either one believes that whatever stock or asset people are currently throwing the most money at is the stock or asset in which one should be invested (capitalization-weighted indexing); or one believes that in the long run free cash flow will determine the price of the stock or asset (free cash flow-based fundamental indexing).
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Even though the idea that free cash flow (i.e., return to the owners of the asset) is an old, well-established valuation concept, converting that concept into an index is quite new. Needless to say, the capitalization-weighted indexing fraternity is fighting fundamental indexing tooth and nail.
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I have no idea if the current fundamental indexes truly reflect the concept of free cash flow to the owners. However, I can say that anyone who disagrees with fundamental indexing (insofar as it represents free cash flow available to the owners) in general, is taking the position that what is being taught in every reputable business and finance school in the country (world?) since the 1930s is wrong.
Mike
