# The Drawback Of Market-Capitalization Weighted Indexing

A market-capitalization weighted index weights the constituent stocks or bonds in proportion of their total value but because the weight of any security included in the index is itself based on the price of the stock, securities whose price has risen are overweighted in the index and securities whose price has declined are under-weighted.

by Obaidullah Jan, ACA, CFA and last modified on May 23, 2019

## Breaking Down the Capitalization-Weighted Index

Capitalization-weighted indexes are widely used because the values change proportionally to the price changes of each component (since market capitalization is determined by the stock price multiplied by the number of shares outstanding). The indices also consider the shareholder base of each component.

Since some companies own shares that are not fully available to the public, most of the indices use the free float factor to adjust calculations. The free float is the percentage of the shares available for trading.

Some investors criticize capitalization-weighted indexes for providing a distorted view of the stock markets

Stocks, also known as equities, represent fractional ownership in a company. Many believe that the primary reason for the distortion is the overweighting toward companies with the largest market capitalization.

## Value-Weighting a Simple Index

Ike knows the solution from what he learned in college. He’ll assign a weight to each company in the index based on the company’s value. This weight will determine how much influence each company will have on the results.

Investors value a company based on its market capitalization, which is the price of its stock times the number of shares outstanding. Bigger companies are more valuable, so they have a higher market capitalization.

Let’s look at a sample index for three of Ike’s companies to see how the process works. The first thing he does is look up the three companies’ stock prices and number of shares outstanding. Then he multiplies them together to get the market capitalization for each. Take a look at the table below to see how that looks:

Company Stock price Shares outstanding Market capitalization
Company A \$200 500,000 \$100,000,000
Company B \$125 1,000,000 \$125,000,000
Company C \$50 200,000 \$10,000,000

Now to get the weights for each company, first add up the market capitalization for each company to get the total. Then take each company’s market capitalization and divide it by the total to get its weight.

Company Stock price Shares outstanding Market capitalization Weight
Company A \$200 500,000 \$100,000,000 43%
Company B \$125 1,000,000 \$125,000,000 53%
Company C \$50 200,000 \$10,000,000 4%

As you can see, total market capitalization = \$235,000,000

Note how small company C has a much lower weight than the bigger companies — 4% compared to the 43% of Company A and the 53% of Company B. That means Company C will have a much smaller impact on the index.

Traders work on the floor of the New York Stock Exchange (NYSE) in New York, U.S. Photographer:… [ ] Michael Nagle/Bloomberg

Market-weighted indexes{amp}amp;nbsp;may end up over-exposed to expensive investments, and underweight more attractively valued ones. That can be a problem.{amp}amp;nbsp;Of course, there are advantages to the approach too. First off, passive investing can often cut your expenses, and that typically helps performance. Secondly, many stocks do fall to zero over time, but indexing, based on market capitalization, tends to steadily reduce exposure to failing companies and increase exposure to{amp}amp;nbsp;growing ones, assuming these trends persist over time. {amp}amp;nbsp;Also, indexing is a straightforward approach to both understand and implement. However, the main risk that comes with market-capitalization weighted index tracking is worth noting.

The risk is that if a stock, sector or even market becomes overvalued, then it naturally becomes a larger portion of the index, when market capitalization weighting is used.{amp}amp;nbsp;Let’s{amp}amp;nbsp;assume stocks are{amp}amp;nbsp;generally effectively valued by the market, but{amp}amp;nbsp;occasionally, the market gets ahead of itself such as with the tech bubble in 2000, and sometimes a little too pessimistic, such as with the aftermath of 2008. These variations are, of course, much easier to gauge in retrospect.

Nonetheless, if these fluctuations in value occur, then with passive indexing you’ll be on the wrong side of them. If something rises in price, then it becomes a larger part of a typical market-capitalization index. For example, if tech stocks rise in value then a passive index based on market{amp}amp;nbsp;capitalization will blindly own{amp}amp;nbsp;more tech stocks over time. That’s great if tech stocks really are the future, but becomes a problem if some tech stocks are just seeing their value get inflated without justification. If some stocks in an index rise above what is reasonable, then a market capitalization weighted index will generally own more of them.

The reverse is true too. If an investment declines in value, then it becomes a smaller part of the index. Normally, that’s fine, even desirable. But if the decline is due to excessive pessimism, then a market-capitalization weighted index may reduce its exposure to a stock right at the point when it’s potentially offering more value.

This is true of countries as well. For example, the U.S. market represents a high weight in global portfolios, because the value of U.S. stocks is so large. In fact, the U.S. makes up around half of many global indices. Some of this is justified by the large earnings power of U.S. companies, but some of it reflects the fact that the U.S. is currently trading at a valuation premium relative to other markets, and this may not last. A dollar of earnings from a U.S. firm is currently trading at a higher value than a dollar of earnings from a firm in other developed markets outside the U.S. That hasn’t always been the case, but if this trend does reverse, then market-capitalization weighted global funds would likely be hurt by it.

Other Weighting Criteria

There are solutions to this issue that still use indexing. For example, weighting exposure by something other than market value can help. This is one reason value-based funds exist. These have a bias to{amp}amp;nbsp;holding{amp}amp;nbsp;potentially more attractively valued companies. For example, weighting can be done based on attributes such as price-to-earnings, dividend yield, EV/EBITDA, price-to-book or a combination of these, and hence apparently overvalued stocks can represent a smaller portion of the fund, or even excluded entirely. Potentially less expensive stocks can be given a higher weighting too.

Another method is to construct an equal-weighted fund, where all stocks have the same weight of the index regardless of anything else. This has some benefits in avoiding any valuation bias whatsoever, but also creates some problems{amp}amp;nbsp;because{amp}amp;nbsp;buying and{amp}amp;nbsp;adjusting a larger number of small companies. It can also work out to be more expensive in terms of transaction cost than market-capitalization weighted indexing. With market-capitalization based indexing, many holdings will naturally drift in a synchronized way with market movements, so less trading is required by the fund. However, with equal-weighting you’re often having to constantly juggle the portfolio to keep weights equal and there’s a cost to that. Also, some indices, such as the Dow Jones Industrial Average use their own weighting criteria and that adds potential problems too.

For this reason moving away from market capitalization weight can tend to drive up your costs, which is not necessarily a good move.

Verdict

Market capitalization indexing does come with a lot of benefits and is broadly a good solution, so we should be reluctant to move away from it. Nonetheless, market capitalization construction is something to keep an eye on. It’s generally a sensible way to construct funds and{amp}amp;nbsp;typically requires less trading to maintain an index. However, it does come with a minor drawback that if valuations move away from what is sensible for some index holdings, then a market capitalization fund will tend to own more of what is expensive and less of what is cheap. It’s hardly a fatal flaw, but one drawback that comes with the other benefits{amp}amp;nbsp;of the simplicity of market-capitalization based indexing. As a result, it’s worth being aware of the construction rules that your funds use.

«{amp}gt;

Traders work on the floor of the New York Stock Exchange (NYSE) in New York, U.S. Photographer:… [ ] Michael Nagle/Bloomberg

Market-weighted indexes may end up over-exposed to expensive investments, and underweight more attractively valued ones. That can be a problem. Of course, there are advantages to the approach too. First off, passive investing can often cut your expenses, and that typically helps performance. Secondly, many stocks do fall to zero over time, but indexing, based on market capitalization, tends to steadily reduce exposure to failing companies and increase exposure to growing ones, assuming these trends persist over time.  Also, indexing is a straightforward approach to both understand and implement. However, the main risk that comes with market-capitalization weighted index tracking is worth noting.

The risk is that if a stock, sector or even market becomes overvalued, then it naturally becomes a larger portion of the index, when market capitalization weighting is used. Let’s assume stocks are generally effectively valued by the market, but occasionally, the market gets ahead of itself such as with the tech bubble in 2000, and sometimes a little too pessimistic, such as with the aftermath of 2008. These variations are, of course, much easier to gauge in retrospect.

Nonetheless, if these fluctuations in value occur, then with passive indexing you’ll be on the wrong side of them. If something rises in price, then it becomes a larger part of a typical market-capitalization index. For example, if tech stocks rise in value then a passive index based on market capitalization will blindly own more tech stocks over time. That’s great if tech stocks really are the future, but becomes a problem if some tech stocks are just seeing their value get inflated without justification. If some stocks in an index rise above what is reasonable, then a market capitalization weighted index will generally own more of them.

The reverse is true too. If an investment declines in value, then it becomes a smaller part of the index. Normally, that’s fine, even desirable. But if the decline is due to excessive pessimism, then a market-capitalization weighted index may reduce its exposure to a stock right at the point when it’s potentially offering more value.

This is true of countries as well. For example, the U.S. market represents a high weight in global portfolios, because the value of U.S. stocks is so large. In fact, the U.S. makes up around half of many global indices. Some of this is justified by the large earnings power of U.S. companies, but some of it reflects the fact that the U.S. is currently trading at a valuation premium relative to other markets, and this may not last. A dollar of earnings from a U.S. firm is currently trading at a higher value than a dollar of earnings from a firm in other developed markets outside the U.S. That hasn’t always been the case, but if this trend does reverse, then market-capitalization weighted global funds would likely be hurt by it.

Other Weighting Criteria

There are solutions to this issue that still use indexing. For example, weighting exposure by something other than market value can help. This is one reason value-based funds exist. These have a bias to holding potentially more attractively valued companies. For example, weighting can be done based on attributes such as price-to-earnings, dividend yield, EV/EBITDA, price-to-book or a combination of these, and hence apparently overvalued stocks can represent a smaller portion of the fund, or even excluded entirely. Potentially less expensive stocks can be given a higher weighting too.

Another method is to construct an equal-weighted fund, where all stocks have the same weight of the index regardless of anything else. This has some benefits in avoiding any valuation bias whatsoever, but also creates some problems because buying and adjusting a larger number of small companies. It can also work out to be more expensive in terms of transaction cost than market-capitalization weighted indexing. With market-capitalization based indexing, many holdings will naturally drift in a synchronized way with market movements, so less trading is required by the fund. However, with equal-weighting you’re often having to constantly juggle the portfolio to keep weights equal and there’s a cost to that. Also, some indices, such as the Dow Jones Industrial Average use their own weighting criteria and that adds potential problems too.

For this reason moving away from market capitalization weight can tend to drive up your costs, which is not necessarily a good move.

Verdict

Market capitalization indexing does come with a lot of benefits and is broadly a good solution, so we should be reluctant to move away from it. Nonetheless, market capitalization construction is something to keep an eye on. It’s generally a sensible way to construct funds and typically requires less trading to maintain an index. However, it does come with a minor drawback that if valuations move away from what is sensible for some index holdings, then a market capitalization fund will tend to own more of what is expensive and less of what is cheap. It’s hardly a fatal flaw, but one drawback that comes with the other benefits of the simplicity of market-capitalization based indexing. As a result, it’s worth being aware of the construction rules that your funds use.

On the other hand, value-weighted indexes seek not only to avoid the losses due to the inefficiencies of market-cap weighting, but to

performance by buying more of stocks when they are available at bargain prices. Value-weighted indexes are continually rebalanced to weight most heavily those stocks that are priced at the largest discount to various measures of value. Over time, these indexes can significantly outperform active managers, market cap-weighted indexes, equally-weighted indexes, and fundamentally-weighted indexes.

Annual return* of Value-Weighted Index over trailing 20 years: 16.1%

The market value of each stock can be calculated by multiplying the stock price with the total number of
shares outstanding
. The sum of the market value of all the component stocks is then divided by a divisor to obtain the final index value.

Many a times, stock price gap up or down following the quarterly earnings report
but often, the direction of the movement can be unpredictable.

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## Example

Work out the index value on 1 Jan 2017 and 31 Dec 2017 based on the following data:

Stock Shares
Outstanding
(Q)
Stock Price Market Capitalization
1 Jan 2017
(P0)
31 Dec 2017
(P1)
1 Jan 2017
(Q×P0)
31 Dec 2017
(Q×P1)
A 25,000 \$15 \$20 \$375,000 \$500,000
B 50,000 \$34 \$40 \$1,700,000 \$2,000,000
C 100,000 \$52 \$60 \$5,200,000 \$6,000,000
D 50,000 \$120 \$100 \$6,000,000 \$5,000,000
Sum 225,000 \$13,275,000 \$13,500,000

Assume that the divisor is 1.

Now, we can work out the relevant weights as follows:

 wA (1 Jan 2017) = \$375,000 = 2.82% \$13,275,000

Similarly, we work out that weights of Stock B, C and D are 12.81%, 39.17% and 45.20% respectively.

The weights for Stock A, B, C and D as on 31 Dec 2017 are 3.77%, 15.07%, 45.20% and 37.66% respectively.

You can see that weights have increased where the stock price has increased and vice versa.

Index as at 1 Jan 2017
= 2.82%×\$15 12.81%×\$34 39.17%×\$52 45.20%×\$120
= 79.38

In the same fashion, we find out that the index value as at 31 Dec 2017 is 71.56. The biggest drag on the index is the decline in price of Stock D because it has the highest weight.

A capitalization-weighted index, ABC, is first published comprising the following public companies A, B and C.

\$30 1,000,000 \$30,000,000 25%
\$60 500,000 \$30,000,000 25%
\$60 1,000,000 \$60,000,000 50%

As can be seen from the table above, although company B’s stock price is two times that of company A’s, their weightage in a capitalization-weighted index are the same as their market values are equal.

The total value of the index is: 30m 30m 60m = 150m. A divisor of 150,000 is selected to start the index off with an even number of 1000.

Initial Index Value = 150m / 150k = 1000

The CWI Composite is a capitalization-weighted index. It consists of four companies only: Company A, Company B, Company C, and Company D. The summary of the current stock prices and the total number of the shares outstanding for each company is given in the table below:

Using the information from the table above, we can calculate the market capitalization of each index component. The market capitalization can be found through the following formula:

Thank you for reading CFI’s explanation of a capitalization-weighted index. CFI is the official provider of the global Financial Modeling {amp}amp; Valuation Analyst (FMVA)™

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• Common Stock
• Diluted Shares Outstanding
• Nikkei Index
• Weighted Average Shares Outstanding

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.

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).

Most index providers adjust their cap-weighted indexes accordingly using a freefloat 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.

## Formula

A market-capitalization weighted index value at any point can be calculated using the following formula:

Market Capitalization-weighted Index
=w1×p1 w2×p2 … wn×pn

Where,
w1 is the weight of first stock,
p1 is the price of first stock,
w2 is the weight of second stock,
p2 is the price of second stock,
wn is the weights of nth stock and
pn is the price of nth stock and so on.

Weight of each security can be calculated as follows:

 wn = Market Cap of Security n Total Market Capitalization
 wn = qn × pn q1 × p1 q2 × p2 … qn × pn

## Lesson Summary

Let’s take a few moments to recap what we’ve learned about value-weighted indexes…

An index tracks the performance of a group of securities and expresses it as a single number. Securities the index tracks can be assigned a weight, which determines how much each individual company has on the index number.

Market capitalization is the market price of a security time the number of shares outstanding. To calculate the value of a value-weighted index, sum the market capitalization for each company and divide it by a divisor which is set initially to make the index a round number.

## Market Capitalization = Stock Price x No. of Shares Outstanding

Thus, the market capitalization of each company in the index is:

• Company A = \$5 x 5,000,000 = \$25,000,000
• Company B = \$10 x 1,000,000 = \$10,000,000
• Company C = \$25 x 500,000 = \$12,500,000
• Company D = \$15 x 1,500,000 = \$22,500,000

The total market capitalization of the index is the sum of the market capitalization of all the components. Therefore, the market capitalization of the CWI Composite is:

CWI Composite = \$25,000,000 \$10,000,000 \$12,500,000 \$22,500,000 = \$70,000,000

The weight of each index component is determined using the formula below:

## 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.

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.

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.

## Stock Index

Ike is a securities analyst for a brokerage firm. He has created a small index for a few local companies called the Ike Index. An index tracks the stock price performance of a group of companies.

So instead of looking up a bunch of different stock prices to see how the local ones are doing, interested investors can just look at the Ike Index to see if the group is doing well or poorly. It’s just like the market averages you hear reported on radio and TV all the time, only smaller.

Ike is getting ready to make some big changes to how he calculates his index numbers. His clients would like to see the index weighted, or how much each individual company has on the index number, to make the larger companies count for more than the smaller ones, since the biggest companies have the most influence on the local job market and economic health.

Many of the most widely followed stock market indices are value-weighted. That includes The NASDAQ Composite Index, and the Wilshire 5000 Total Market Index.

## Stock Prices Change

Let’s see what happens later when the stock prices change. Ike will redo the table to reflect the new stock prices. That will also change the market capitalization for each company along with the total and weights.

Company Stock price Shares outstanding Market capitalization Weight
Company A \$195 500,000 \$97,500,000 42%
Company B \$120 1,000,000 \$120,000,000 52%
Company C \$70 200,000 \$14,000,000 6%

Adding up the market capitalization, we get a total market capitalization of \$231,500,000. Therefore, total market capitalization divided by divisor equals 985.1. Note that Company C’s weight has gone from 4% to 6% since the stock price had a big jump, but when we divide the total market capitalization by the divisor to get the new index value, we get \$231,500,000 / 235,000 = 985.1.

We see that the index value has fallen from 1000 to 985.1 even though the stock prices for the three companies increased by a total of \$10! This appropriately reflects the price declines in the bigger companies.

## 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.

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