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 are calculated simply by assigning the same weight to each constituent in the portfolio. When some securities see greater capital growth, they become over-weighted. To maintain balance, these indices require frequent rebalancing. It’s important to note that they may not truly represent the performance of all investors in those securities.

Market-capitalization Weighting

Market capitalization weighting involves multiplying a company’s shares by its market value, creating a proportion of total market capitalization. This weighting aligns with market momentum. Many index funds use this method because it minimizes turnover. However, as a security’s price increases, investors end up holding more of it compared to 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

Fundamental-weighted indices aim for a “value tilt.” They weigh securities based on factors like book value, earnings, and dividends. Unlike market capitalization indices with momentum, these rebalance for “contrarian” positions when factor prices are 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 rebalance automatically with price changes. When a security outperforms, its weight in the index increases as its market capitalization rises.

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

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