Indexes constructed to measure the characteristics and performance of specific markets or asset classes are typically market cap-weighted, meaning the index constituents are weighted according to the total market cap or market value of their available outstanding shares.
In market cap-weighted indexes, a company’s representation within the index is based on its size, and its performance contributes to the performance of the overall index proportionately.
In other words, the company with the largest market cap will represent the largest weight in the index, meaning mega cap companies like Apple will impact the performance of the overall index more than a small cap company will.
This method of weighting index constituents remains the most commonly-used today. Despite the development of hundreds of alternatively-weighted indexes in recent years, market cap-weighted indexes remain relevant—they are utilized to measure changes equity markets globally markets and measure changes in the overall size of the market(s) over time.
What does it mean for an index to be float adjusted?
The original market cap-weighted indexes included all of a company’s outstanding shares. This method is problematic in cases where companies have shares that are not fully available for trade on the open market, such as government-held shares or large privately-controlled holdings. Float adjusting an index means that only shares that are readily available to the public are represented in the index.
What are alternatively-weighted indexes?
There are a number of alternatively-weighted index construction approaches to complement traditional market cap-weighted indexes. In alternatively-weighted indexes, constituent weights are determined independently of market measures of company size (i.e., market cap). These indexes are designed to target specific objectives such as reducing risk or improving diversification. Alternative weighting mechanisms include equally weighting index constituents and basing weights on fundamental criteria such as revenue, cash dividend rates, and book value.
What are factor indexes?
Academic research has long maintained that stock performance can largely be explained by several common characteristics such as size, value, price momentum, quality, and volatility. Factor indexes are designed to capture the performance of these characteristics. These indexes are intended to offer more focused exposures to factors than their market cap-weighted counterparts. A factor index sets out to capture factor exposures in a controlled and considered way. Single factor indexes and factor combination indexes, which can be tailored depending on the desired exposures, are common solutions used by investors.
What are thematic indexes?
A thematic index is designed to follow a generally-accepted investment theme rather than a particular country, sector, or market segment. An example is an index comprised of companies listed in developed markets such as the UK and US that derive significant revenue from emerging markets. The purpose of this investment strategy would be to gain exposure to emerging markets without directly purchasing stocks issued by companies listed in emerging market countries, hence avoiding the country and currency risks and higher trading costs associated with some emerging markets investments.