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How are indexes weighted?

An index’s selection methodology can only tell you so much about how it will perform over time. Often its real secret sauce is how its securities are weighted within the basket.

We cover a few of the most well-known weighting schemes below:

The price-weighted index

Price-weighted indexes aren’t particularly common anymore. Still, one of the world’s most widely tracked indexes – the Dow Jones Industrial Average – uses price weighting, so the process is worth understanding.

A price-weighted index is one which includes an equal number of shares for each security in its basket – meaning the higher a security’s price goes, the more it will drive the index’s overall value.

For example, let’s look at a hypothetical five member price-weighted index basket:

Security

Price

Share

Weighting

A

$3

10

10%

B

$1

10

3%

C

$7

10

23%

D

$9

10

30%

E

$10

10

33%


At $10/share, Security E has the highest price and therefore the highest weighting in the index. Security B, on the other hand, costs only $1/share; its weighting barely makes a blip in the overall basket.

A price-weighted index has many advantages: its weighting scheme is simple to understand and its daily value easy to calculate (it’s simply the sum of all the security prices divided by the total number of constituents).

The problem is, a security’s price alone doesn’t necessarily communicate its true market value. It ignores market forces of supply and demand. To fix this, we need a different weighting scheme.

The market-capitalization weighted index

Market-capitalization weighted indexes (or market cap- or cap-weighted indexes) weight their securities by market value as measured by capitalization: that is, current security price * outstanding shares. The vast majority of equity indexes today are cap-weighted, including the S&P 500 and the FTSE 100.

In a cap-weighted index, changes in the market value of larger securities move the index’s overall trajectory more than those of smaller ones. Let’s look at the same hypothetical five-member index, this time cap-weighted:

Security

Current Price

Outstanding Shares

Market cap

Weighting

A

$3

50

150

15%

B

$1

50

50

5%

C

$7

70

490

51%

D

$9

20

180

19%

E

$10

10

100

10%

 

 

Total market cap

970

100%

At $7/share, Security C doesn’t have the highest price, but it does have the largest market capitalization and thus the highest weighting in our index. Meanwhile, Security E, the highest priced security but also the one with the smallest number of outstanding shares, has fallen from the largest piece of the pie to second smallest. 

The advantage of a cap-weighted index is obvious: It reflects the way markets actually behave. Larger companies do in fact have more dramatic effects on the overall market than smaller companies. It’s also a self-rebalancing methodology, in that as a company’s price or outstanding share quantity changes, so too does the proportions of stocks in the index basket.

But cap-weighted schemes aren’t perfect. For example, sometimes companies have shares that aren’t fully available for trade on the open market (such as government-held shares, or large privately-controlled holdings). In this case, pure cap weighted schemes would misrepresent the actual investible market cap available.

Most index providers adjust their cap-weighted indexes accordingly using a free float factor, or the percentage of shares available for trading.  

Free Float Shares = (Shares x Free Float Factor)

So the free float market cap would be: 

Float Market Cap = (Price x Shares x Free Float Factor)

There’s a more systemic downside to cap weighting, in that such indexes inherently assume that the EMH always holds—which isn’t necessarily true. Recent research shows that cap-weighted indexes tend to give too much weight to securities the market has overvalued and too little weight to ones it has undervalued. As a result, true market value is skewed.

Alternative weighting schemes to cap-weighting have gained more favor in recent years. These are covered briefly in the next section.

Other weighting schemes

In an equally-weighted index, all the securities in the basket are, as it sounds, weighted in equal amounts. For example, take our hypothetical example index:

Stock

Price

Share

Weighting

A

$3

 2

20%

B

$1

 6

20%

C

$7

 0.86

20%

D

$9

 0.67

20%

E

$10

 0.60

20%


Equal weighting is a highly diversified scheme, and one that avoids the cap-weighting pitfall of overweighting overpriced stocks and underweighting underpriced stocks. But it’s hard to maintain long-term, as fund managers must constantly rebalance their portfolios due to daily price fluctuations. Basket turnover is much higher than a cap-weighted index, meaning that any funds tracking it will often be more expensive than comparable cap-weighted ones.

What’s more, the need to invest equally all securities can cause problems in more illiquid markets or asset classes, as substantial investment by any one player can sometimes end up moving those markets instead of reflecting them.

Recently, new types of indexes have been introduced that eschew market pricing altogether as a means of weighting, and thus determine the value of their securities via other metrics. 

Risk-weighted indexes, for example, assign security weights based on common assessments of risk. In a risk-weighted index, securities are weighted by the inverse of their variance, so that securities with lower historical volatility end up with higher weights in the index. Thus you end up with an index whose securities, if replicated in a fund, would offer as little portfolio risk as possible.

Fundamentally-weighted indexes instead weight their constituents based on their financial health as measured by accounting figures, such as sales, earnings, book value, cash flow and dividends. The assumption here is that these descriptors offer a better estimation of a company’s intrinsic value than market capitalization.