Stock market indices could be segmented by their index weight methodology, or the rules on how stocks are allocated in the index, independent of its stock coverage.
For example, the S&P 500 and the S&P 500 Equal Weight both covers the same group of stocks, but S&P 500 is weighted by market capitalization and S&P 500 Equal Weight is an equal weight index.
Below is sample of common index weighting methods. In practice, many indices will impose constraints, such as concentration limits, on these rules.
- Market-Capitalization Weighting
It based indices weight constituent stocks by its market capitalization (often shortened to "market-cap"), or its stock price by its number of shares outstanding, divided by the total market capitalization of all the constituents in the index.
Under Capital Asset Pricing Model, the market-cap weighted market portfolio, which could be approximated with the market-cap weighted equity index portfolio, is mean-variance efficient, meaning that it produces the highest return for a given level of risk.
Tracking portfolios of the market-cap weighted equity index could also be mean-variance efficient under the right assumptions, and they could be attractive investment portfolios.
A market-cap weighted index can also be thought of as a liquidity-weighted index since the largest-cap stocks tend to have the highest liquidity and the greatest capacity to handle investor flows; portfolios with such stocks could have very high investment capacity.
- Free-float adjusted Market-Capitalization Weighting
It based indices adjust market-cap index weights by each constituent's shares outstanding for closely or strategically held shares that are not generally available to the public market.
Such shares may be held by governments, affiliated companies, founders, and employees.
Foreign ownership limits imposed by government regulation could also be subject to free-float adjustments.
These adjustments inform investors of potential liquidity issues from these holdings that are not apparent from the raw number of a stock's shares outstanding.
Free-float adjustments are complex undertakings, and different index providers have different free-float adjustment methods, which could sometimes produce different results.
- Price Weighting
It based indices weight constituent stocks by its price per share divided by the sum of all share prices in the index.
A price-weighted index can be thought of as a portfolio with one share of each constituent stock. However, a stock split for any constituent stock of the index would cause the weight in the index of the stock that split to decrease, even in the absence of any meaningful change in the fundamentals of that stock.
This feature makes price-weighted indices unattractive as benchmarks for passive investment strategies and portfolio managers.
Nonetheless, many price-weighted indices, such as the Dow Jones Industrial Average and the Nikkei 225, are followed widely as visible indicators of day-to-day market movements.
Reprinted from eToro, the copyright all reserved by the original author.
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