<P> Investors use theories such as modern portfolio theory to determine allocations . This considers risk and return and does not consider weights relative to the entire market . This may result in overweighting assets such as value or small - cap stocks, if they are believed to have a better return for risk profile . These investors believe that they can get a better result because other investors are not very good . The capital asset pricing model says that all investors are highly intelligent, and it is impossible to do better than the market portfolio, the capitalization - weighted portfolio of all assets . However, empirical tests conclude that market indices are not efficient . This can be explained by the fact that these indices do not include all assets or by the fact that the theory does not hold . The practical conclusion is that using capitalization - weighted portfolios is not necessarily the optimal method . </P> <P> As a consequence, capitalization - weighting has been subject to severe criticism (see e.g. Haugen and Baker 1991, Amenc, Goltz, and Le Sourd 2006, or Hsu 2006), pointing out that the mechanics of capitalization - weighting lead to trend - following strategies that provide an inefficient risk - return trade - off . </P> <P> Also, while capitalization - weighting is the standard in equity index construction, different weighting schemes exist . First, while most indices use capitalization - weighting, additional criteria are often taken into account, such as sales / revenue and net income (see the "Guide to the Dow Jones Global Titan 50 Index", January 2006). Second, as an answer to the critiques of capitalization - weighting, equity indices with different weighting schemes have emerged, such as "wealth" - weighted (Morris, 1996), "fundamental" - weighted (Arnott, Hsu and Moore 2005), "diversity" - weighted (Fernholz, Garvy, and Hannon 1998) or equal - weighted indices . </P> <P> There has been an accelerating trend in recent decades to invest in passively managed mutual funds that are based on market indices, known as index funds . SPIVA's annual "U.S. Scorecard," which measures the performance of indices versus actively managed mutual funds, finds the vast majority of actively managed mutual funds underperform their benchmarks . One study claimed that over time, the average actively managed fund has returned 1.8% less than the S&P 500 index - a result nearly equal to the average expense ratio of mutual funds (fund expenses are a drag on the funds' return by exactly that ratio). Since index funds attempt to replicate the holdings of an index, they eliminate the need for--and thus many costs of--the research entailed in active management, and have a lower churn rate (the turnover of securities which lose fund managers' favor and are sold, with the attendant cost of commissions and capital gains taxes). </P>

The dow jones industrial and utility averages include a relatively small number of stocks