The Investor's Guide to Index Weighting

A Deep Dive into Stock Market Index Weighting Methods

Stock indexes are widely used to track the performance of a particular market or segment of the market. Index weighting is an important factor in determining the performance of an index, as it determines the relative importance of each stock in the index. There are several different methods for index weighting, each with its own advantages and disadvantages. The most widely used method is market capitalization weighting, where the weight of each stock in the index is proportional to its market capitalization. Other methods include equal weighting, price weighting, and fundamental weighting.

In this article, we will take a closer look at the different methods of stock index weighting and their impact on index performance. We will also discuss the factors to consider when choosing an index and the role of index weighting in investment strategy. Whether you are a seasoned investor or just starting out, understanding the different methods of stock index weighting is crucial for making informed investment decisions.

Price Weighted Index

A type of stock market index in which each component is weighted based on its price per share. This means that the higher the price of a stock, the more weight it has in the index. Example of indexes calculated using price weighted method are Dow Jones Industrial Average and the Nikkei 225.

Sample Calculation:

To calculate a PWI, you divide each price of stocks by total stocks in the index.

Advantages

• Easy to Calculate: The calculation of a price-weighted index is simple and straightforward, requiring only the prices of the stocks in the index and a divisor. 

• Reflects Stock Prices: A price-weighted index reflects the prices of individual stocks in the index, which can be useful for investors who believe that higher-priced stocks are more representative of the overall market. 

Disadvantages

• Disproportionate Impact: Price-weighted indexes can give a disproportionate impact to higher-priced stocks, even if they are only a small part of the index. This can result in the index being heavily influenced by a few large companies, which may not accurately reflect the overall performance of the market. 

• Price Changes Affect Weighting: Price weighting can also be affected by changes in the prices of individual stocks. If a high-priced stock in the index experiences a significant price change, it can significantly impact the overall value of the index, even if the other components of the index remain relatively stable. 

A price-weighted index can be a useful tool for investors who want to track the performance of individual stocks in the index. However, it may not be the best option for investors who are looking for a more accurate representation of the overall market, as it is heavily influenced by the prices of individual stocks and does not reflect the relative size of companies in the index. 

Market Capitalization Index

Market capitalization index weighting is a method used to weigh the stocks in a stock market index based on the market capitalization (market cap) of each company. The market cap of a company is calculated as the total number of its outstanding shares multiplied by the current stock price.

Market cap weighting is used by some of the world's most widely followed stock market indexes, including the FTSE 100 and the NASDAQ 100. In a market cap weighted index, the larger a company's market cap, the greater its weight in the index. This means that companies with a higher market cap have a greater impact on the overall performance of the index.

Sample Calculation:

Advantages

• Easy to understand and implement: Market cap weighting is a simple and intuitive approach to constructing an index. It is easy to understand and implement, making it accessible to both novice and experienced investors. 

• Reflects market sentiment: Market cap weighting captures the market's current perception of a company's value. When investors value a company more, they will be willing to pay a higher price per share, which will increase the company's market capitalization and its weighting in the index. 

• Low turnover: Because market cap weighting changes only when the market capitalization of a company changes, it results in low turnover. This means that investors can avoid unnecessary transaction costs and taxes associated with frequent buying and selling of stocks.

Disadvantages

• Overrepresentation of large companies: Market cap weighting can lead to the overrepresentation of large, established companies in an index, which can skew the index's performance. This means that smaller companies may not receive the same level of representation in the index, even if they are performing well. 

• Limited diversification: Market cap weighting can limit diversification opportunities. Smaller companies may not have large market capitalizations, so they may have a smaller weighting in the index, making it difficult for investors to gain exposure to them through passive investing strategies. 

• Vulnerable to bubbles: Market cap weighting can make an index vulnerable to bubbles, which occur when investors become overly optimistic about a particular sector or company. If the market capitalization of a company or sector becomes inflated due to irrational exuberance, then its weighting in the index will increase, even if its underlying fundamentals do not support such a high valuation. 

Float-adjusted Market-capitalization Index

Float-adjusted market-capitalization weighting index is a type of market index that is calculated based on the market capitalization of the underlying assets. However, unlike traditional market-capitalization weighted indexes, float-adjusted indexes consider only the value of the freely tradable shares, or the "float," of each company, rather than the total number of outstanding shares.

For example, let's say that a company has a total of 100 million shares outstanding, but only 50 million of those shares are available for trading on the stock market. If the company's market capitalization is $1 billion, the float-adjusted market capitalization would be calculated based on the value of the 50 million freely tradable shares, rather than the value of the entire 100 million shares outstanding. Examples of index using float adjusted market cap method are S&P 500 (USA), MSCI World Index (Worldwide), and IDX Composite Index (Indonesia).

Sample Calculation:

Advantages

• Provides a more accurate representation of the market value of the companies in the index by considering only the freely tradable shares, which are more representative of the true supply and demand for the stock. 

• The index is less susceptible to large swings in the price of individual stocks, as the weighting is based on the freely tradable shares rather than the total number of outstanding shares. 

• The index reflects changes in the market more quickly, as it is updated more frequently than traditional market-capitalization weighted indexes. 

Disadvantages

• Companies with a small float may be underrepresented in the index, as their market capitalization will be based on only a small portion of their total outstanding shares. 

• The index may be biased towards larger companies, as they tend to have a larger percentage of their shares available for trading. For example, the top 5 companies in the S&P 500 (Apple, Microsoft, Alphabet/Google, Amazon, and Facebook) accounted for around 15% of the index's total market cap. These companies are all in the technology sector, which means that the S&P 500 has a heavy bias towards technology stocks. While these companies are certainly important and influential, they don't necessarily represent the full diversity of the US stock market. 

• It may require more frequent rebalancing than traditional market-capitalization weighted indexes, as changes in the float of individual companies can affect the weighting of the index. 

Equal Weight Index

Equal weight indexing is an alternative method of weighting the stocks in a stock market index that assigns an equal weight to each stock in the index, regardless of its market capitalization (market cap). Unlike market cap weighting, where the weight of a stock in the index is based on its market cap, equal weighting gives each stock an equal share of the total weight of the index.

Sample Calculation:

In an equal weight index, the weight of each stock is determined by dividing the total weight of the index by the number of stocks in the index. For example, if there are 100 stocks in the index, each stock would have a weight of 1% in the index. This weighting method is used by several stock market indexes, including the FTSE All-World Equal Weighted Index and the TOPIX Equal Weight Index (Japan).

Advantages

• Diversification: An equal weighted index provides diversification benefits since each stock is given equal weighting. This means that the performance of any single stock has less impact on the overall index performance. It also reduces the impact of large, mature companies on the index and increases the impact of smaller, growing companies. 

• Potential for higher returns: Equal weighted indexes tend to have a higher exposure to small-cap and mid-cap stocks, which have the potential for higher returns compared to large-cap stocks. 

• Rebalancing benefits: Since an equal weighted index is rebalanced periodically to maintain equal weighting, it forces investors to sell overvalued stocks and buy undervalued stocks, which can potentially lead to higher returns. 

Disadvantages

• High turnover and transaction costs: The periodic rebalancing of an equal weighted index can result in higher turnover and transaction costs, which can erode returns over time. The need of periodic rebalancing more than market cap index is that as stock prices fluctuate, the weights of individual stocks in the index can quickly become imbalanced. 

• Lower liquidity: The equal weighting of all stocks means that smaller companies with lower liquidity may have a larger impact on the index performance, which can increase the volatility of the index. 

• Higher risk: Equal weighted indexes tend to have a higher concentration of small-cap and mid-cap stocks, which can be riskier and more volatile than large-cap stocks. This means that equal weighted indexes may not be suitable for all investors, particularly those with a low risk tolerance. 

Fundamental Index

An index method of weighing the stocks in a stock market index based on the financial and economic fundamentals of each company, such as earnings, sales, dividends, and book value. The goal of fundamentals index weighting is to create an index that is more representative of the true value of each company and less influenced by short-term market fluctuations.

The weight of each stock is determined by a combination of its financial and economic fundamentals, such as earnings, sales, dividends, and book value. The weight of each stock is then adjusted periodically, usually on a quarterly or semi-annual basis, to reflect changes in the underlying fundamentals. Examples of indexes that use fundamentals weighting are NASDAQ-100 Index (USA), STOXX Europe 600 Index (Europe).

Sample Calculation:

Advantages

• Better representation of the market: Fundamental indexes can offer a better representation of the market than traditional market-cap weighted indexes because they take into account a company's financial health, not just its size. By weighting stocks based on their underlying fundamentals, rather than their market capitalization, a fundamentals index is less susceptible to short-term market fluctuations and more reflective of the true value of each company. 

• Reduced concentration risk: Market-cap weighted indexes can become heavily concentrated in a few large companies, while fundamental indexes can provide a more diversified portfolio. 

• Reduced turnover: Fundamental indexes tend to have lower turnover than traditional market-cap weighted indexes. This can reduce trading costs and tax implications. 

Disadvantages

• Higher fees: Fundamental indexes may have higher fees compared to traditional market-cap weighted indexes due to the additional research and analysis required. 

• Potential for lower liquidity: Fundamental indexes may have a lower trading volume and less liquidity than traditional market-cap weighted indexes. 

• Subjectivity: The selection of fundamental factors and the weighting methodology is subjective and may vary across providers, which can lead to different results. 

• Limited exposure: Fundamental indexes may not offer exposure to certain sectors or industries that are not included in the selection criteria. 

---

OCBC NISP Ventura

February 2023 Newsletter