Capitalization-Weighted Index Explained

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Capitalization-weighted index –>

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Capitalization-Weighted Index Explained

There is no perfect index weighting method as each one has its own strengths and weaknesses.

Price Weighting

In price-weighted indices, an equal number of shares of each security is purchased and the beginning divisor is usually set to the total number of shares in the portfolio. Using this method, the highest-priced stocks have the highest weightings within the portfolio regardless of their total market capitalization. In order for stock splits not to change all portfolio weights, the divisor must be adjusted. Price-weighted indices are the easiest to calculate but generally have arbitrary index weightings.

Equal Weighting

Equal-weighted indices involve a simple calculation to find the appropriate weight of each constituent within the portfolio. Since securities that experience greater capital appreciation during a period will naturally become over-weighted in these indices, a rebalance to equal weighting helps to avoid allocating the most capital to the most expensive stocks. Equal-weighted indices give involve frequent rebalancing and don’t necessarily reflect the overall performance of all investors in those securities.

Market-capitalization Weighting

To weight an index by market capitalization, a company’s shares outstanding are multiplied by its per-share market value and calculated as a proportion of total market capitalization. This helps to introduce somewhat of a natural momentum factor into the market-cap weighted index as price changes generally correspond with market capitalization and therefore the desired weighting in the index. Market capitalization indices are commonly used by index funds due to minimal turnover, but cause the investor to hold more of a constituent security as its price (and therefore market capitalization) increases faster than the broader market.

Float-adjusted Market-capitalization Weighting

<>In float-adjusted market-capitalization weighting, the weight of each constituent security is determined by adjusting market capitalization for its market float. Float refers to the regular shares a company has issued to the public that are available for investors to trade. Most market capitalization-weighted indices are adjusted for float.

Fundamental Weighting

Attempts to give the index a “value tilt” by weighting constituent securities based on certain factors such as book value, earnings, and dividends. While market capitalization indices mostly take on a momentum tilt, fundamental-weighted indices will do the opposite by rebalancing to “contrarian” positions when the price paid for the given factor is low.

Question

Which type of index weighting method is naturally rebalanced by price changes in its constituent securities?

Solution

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The correct answer is B.

Market-capitalization indices tend to rebalance automatically with changes in price since the outperformance of one constituent security against the broad portfolio will generally increase the weight of that security within the index in line with the security’s increase in proportion of total market capitalization.

Option A is incorrect. Unless all constituent securities move together, any price changes in equal-weighted indices must be frequently rebalanced.

Option C is also incorrect. Fundamental-weighted indices must also be constantly rebalanced based on price changes and updates in company fundamentals.

Reading 37 LOS 37d:

Compare the different weighting methods used in index construction

capitalization-weighted index – Investment & Finance Definition

A stock index in which each stock affects the index in proportion to its market value. The NASDAQ Composite Index, the S&P 500 Index, the Wilshire 5000 Equity Index, the Philadelphia Stock Exchange’s Gold & Silver Sector Index, and the Utility Sector Index are examples of capitalization-weighted indices. Also called market-value weighted indices.

How Different Weighted Indexes Play Into ETFs

Many Exchange Traded Funds (ETFs) use indexes as their underlying benchmarks, so it is equally important to understand the different types of indexes. Your ETF investing strategy depends on them. The three main types of indexes are price-weighted, value-weighted, and pure unweighted. 

Price-Weighted Indexes

With a price-weighted index, the index trading price is based on the trading prices of the individual securities (stocks) that comprise the index basket (known as components).

In other words, the stocks with the higher prices will have more impact on the movement of the index than stocks with lower prices, since their price is “weighted” higher. 

If a stock goes from $100 to $110, because its price is higher, it will move the price-weighted index more than a stock that goes from $20 to $30, even though the percentage move is greater for the lower-priced stock.

One of the most popular price-weighted indexes is the Dow Jones Industrial Average (DJIA), which consists of 30 different components. In this index, the higher-priced stocks move the index more than those with lower trading prices, ergo price-weighted. 

Value-Weighted Indexes

In the case of a value-weighted index, the amount of outstanding shares comes into play. To determine the weight of each stock in a value-weighted index, the basic formula (without getting too complex for demonstrative purposes) is to multiply the price of the stock by the number of outstanding shares. 

If Stock ABC has 6 million outstanding shares and trades at $15, then its weight in the value-weighted index is $90 million (15 x 6). But if stock XYZ is trading at $30, and has only 1 million outstanding shares, its weight is $30 million (30 x 1).

So, in a value-weighted index, ABC would have more impact in the movement of the index, but in a price-weighted one, it would have less value since its price is lower. Some examples of value-weighted indexes, sometimes called capitalization-weighted indexes, are the popular MSCI family of strategy indexes.

Unweighted Indexes

The third variation of weighted indexes is the unweighted index, which some call the equal-weighted.   All stocks, regardless of share volumes or price, have an equal impact on the index price. The price change in the index is based on the percentage return of each component.

Say there are three stocks in our unweighted index example: ABC, XYX, and MNO. Regardless of how many shares you have of each stock or the actual trading price, look at the percentage of price movement. So if ABC is up 50% and XYZ is up 10% and MNO is up 15%, the index is up 25% = (50+10+15) / 3 (the number of stocks in the index).

This calculation is based on an arithmetic average, but some unweighted indexes will use a geometric average calculation as well. So then the formula would change to (1.5 + 1.1 + 1.15) [1/3]. Typically, the geometric formula will generate a slightly lower percentage than the arithmetic formula, but still should be relatively close.

Index Summary

While there are other types of weighted indexes—revenue-weighted indexes, fundamentally-weighted indexes, factor- and even float-adjusted indexes—the three outlined here are the ones most typically used with ETFs.

Unlike funds that are chosen by a manager, ETFs are passive with stocks selected automatically to match a particular aspect of the market. Based on the type of fund, different proportions of the underlying stocks are held. Because ETFs are automated, they typically carry lower operating costs.

There are many arguments about which types of weighted indexes are best, but in the end, it depends on your personal situation.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor, and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.

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