Weighting Methods Used in Index Construction

There is no perfect index weighting method as each one has its own strengths and weaknesses.

Price Weighting

In price-weighted indices, an equal number of shares of each security is purchased, and the beginning divisor is usually set to the total number of shares in the portfolio. Using this method, the highest-priced stocks have the highest weightings within the portfolio regardless of their total market capitalization. For stock splits not to change all portfolio weights, the divisor must be adjusted. Price-weighted indices are the easiest to calculate but generally have arbitrary index weightings.

Equal Weighting

Equal-weighted indices involve a simple calculation to find the appropriate weight of each constituent within the portfolio. Since securities that experience greater capital appreciation during a period will naturally become over-weighted in these indices, a rebalance to equal weighting helps to avoid allocating the most capital to the most expensive stocks. Equal-weighted indices involve frequent rebalancing and don’t necessarily reflect the overall performance of all investors in those securities.

Market-capitalization Weighting

To weight an index by market capitalization, a company’s shares outstanding are multiplied by its per-share market value and calculated as a proportion of total market capitalization. This helps introduce a natural momentum factor into the market-cap weighted index as price changes generally correspond with market capitalization and, therefore, the desired weighting in the index. Market capitalization indices are commonly used by index funds due to minimal turnover but cause the investor to hold more of a constituent security as its price (and therefore market capitalization) increases faster than the broader market.

Float-adjusted Market-capitalization Weighting

In float-adjusted market-capitalization weighting, the weight of each constituent security is determined by adjusting market capitalization for its market float. Float refers to the regular shares a company has issued to the public available for investors to trade. Most market capitalization-weighted indices are adjusted for float.

Fundamental Weighting

Attempts to give the index a “value tilt” by weighting constituent securities based on certain factors such as book value, earnings, and dividends. While market capitalization indices mostly take on a momentum tilt, fundamental-weighted indices will do the opposite by rebalancing to “contrarian” positions when the price paid for the given factor is low.

Question

Which type of index weighting method is naturally rebalanced by price changes in its constituent securities?

1. Equal.
2. Fundamental.
3. Market-capitalization.

Solution

The correct answer is C.

Market-capitalization indices tend to rebalance automatically with changes in price since the outperformance of one constituent security against the broad portfolio will generally increase the weight of that security within the index in line with the security’s increase in proportion of total market capitalization.

A is incorrect. Unless all constituent securities move together, any price changes in equal-weighted indices must be frequently rebalanced.

B is incorrect. Fundamental-weighted indices must also be constantly rebalanced based on price changes and updates in company fundamentals.