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I would like to know why ETF's like Vanguard S&P 500 are so popular as opposed to building an index that tracks that top 500 biggest profit makers. Companies like Uber and WeWork can be in the S&P 500 despite them (Still) being losing companies, so maybe it's not that attractive to track companies by market cap?

  • Company profits change from year to year. Consistently paying high dividends can be thought of (imperfect though it may be) as a proxy for highly profitable companies. – RonJohn Jul 15 '19 at 17:34
  • As a supplement to @RonJohn's comment, there are dividend-based ETFs. – Kevin Jul 15 '19 at 17:48
  • @Kevin but some companies don't pay dividends every year. Why measure dividends and not profit? – Joel_Blum Jul 15 '19 at 18:02
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    No company is guaranteed to pay dividends every quarter, but there are many companies which have paid them for a long time. For example, VYM focuses on "This index fund seeks to track a benchmark that provides broad exposure to U.S. companies that are dedicated to consistently paying larger-than-average dividends". – RonJohn Jul 15 '19 at 18:14
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Because most of the growth in an index fund is not due to dividends paid by the stocks it holds, but by the increase in the price of the stocks. That increase has no obvious, direct relationship to corporate earnings or to dividends paid. There are plenty of stocks (e.g. Tesla: https://ir.tesla.com/investor-faqs ) that don't pay dividends, but whose share price increases.

An index fund BY DEFINITION tracks the stocks that make up an index. If that's not what you want, you can find funds that invest in mostly dividend-producing stocks, or which pick their stocks by corporate earnings, or which choose stocks by a multitude of other criteria. Searching for "mutual funds that invest in dividend stocks" returns about 10 million hits, "by corporate earnings" about 66 million.

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There are filtered S&P500 funds which seek to filter the companies that would be in the index based on some criteria like you lay out but the expense ratios on those funds are generally higher than the ones charged by the big index trackers; but they exist. So only companies with market cap over X and fully diluted profit per share of Y is an index that might exist. Whether or not that actually outperforms the S&P500 would need to be researched, then further whether or not it would outperform the vanilla S&P500 index fund net of fees is another point to research.

But remember "profit" is, to some extent, an accounting construct and stock price performance does not correlate to profit. There are plenty of companies that run at negative profit (loss) but the equity is radically outperforming the S&P500. So why not use positive free cash flow rather than positive net profit?

There are A LOT of different indices. Whether or not there is one with sufficient assets under management to warrant the extremely low maintenance fee of the big S&P500 options such that you, the investor, will actually benefit is another story.

  • " the expense ratios on those funds are generally higher ", I don't understand why though. The bottom line profits are publically accessible, it's as easy as measuring market cap index. – Joel_Blum Jul 15 '19 at 18:05
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    To some extent it takes a certain amount of dollars to run a fund. 0.03% of a billion dollars is a lot more dollars than 0.3% of a million dollars. The scale of the S&P500 tracking funds helps to facilitate the almost negligibly low expense ratios; but the investor pays 10x more in fees. – quid Jul 15 '19 at 18:07
  • I understand. But what is it about market cap that attracts investors? Or maybe if you could combine market cap with profits so as to dilute companies like Uber and WeWork. Would you agree that market cap indexes have a strong history, which gives them an edge nowadays? – Joel_Blum Jul 15 '19 at 18:09
  • What difference does it make? The idea of an index fund came to market before computers, the index one Vanguard chose was the S&P 500. Now the index funds have literally trillions of dollars in aggregate and Standard and Poors keeps coming up with umpteen different indices which fund management companies then try to roll in to ETFs and some attract some money. BUT, either way, it's not clear any of these alternate broad indices can actually consistently outperforms the S&P500 anyway. You're operating on the assumption that your idea would beat the S&P500; but it might not. – quid Jul 15 '19 at 18:12
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    Sure, and it also might not and it also might be materially worse, but either way it will most probably be more expensive. – quid Jul 15 '19 at 18:18
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Market-cap weighting is uniquely preferred according to the efficient market hypothesis. By owning the S&P 500, you own shares of "the market" (at least a significant part, large US companies -- you should own other asset classes too). The market caps reflect the collective capital-allocation decisions of professional investors, on which you can free-ride. This takes into account not only current earnings, but projected future earnings and various kinds of risk. Using a weighting other than market cap is an attempt to beat the market, which is very difficult and will likely lag the market instead. If investing based purely on current earnings were most effective, everyone would already be doing it and the market caps would reflect it.

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They're so popular because it's an easy way to make money.

Sure you supposedly could beat the market, but it's going to take a whole lot of work. You're going to have to read financial statements for hundreds of hours before you can decide which companies are going to outperform the market in a significant way.
So you could either throw money into an index fund every month or do some research into stocks you currently own and stocks you might want to own and then decide which of them is the best return for your money every single time you want to invest money.

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