Index weighting

Introduction

An index is used to measure changes in the economy or securities market.  In securities markets, the index is an imaginary portfolio of securities representing the entire market or market segment.  Each index has its own set of inclusion-exclusion criteria (filter) and calculation methodology.  The typical measure of an index is its weighted average, in which each unit of the index to be averaged is assigned a weight.  The weight determines the relative importance of the unit to the measure. The performance of an index is expressed as the percentage change of the baseline measure1,2.

Index weighting

Market-cap weighted index.  The index value is the average market capitalization of all stocks in the index (e.g., the S&P 500).  Larger companies account for a greater portion of the index3.  The main advantage of the index is its simplicity.   The main disadvantage is that the index value is heavily influenced by stocks with the largest market caps.  The index performs best when large cap stocks gain momentum and outperform smaller capitalized stocks.  Conversely, the index performs worst when large cap stocks lose momentum and underperform smaller capitalized stocks4.  Momentum bias is the dominating influence of high-momentum, overvalued stocks compared to low-momentum, undervalued stocks5.

Equal-weighted index.  The index is designed to give the same weight, or importance, to every stock in the portfolio.  The main advantages are: 1) small companies have as much weight as large companies6, and 2) the index is unaffected by momentum bias5.  The main disadvantages are: 1) equal-weighted indices tend to have higher rates of stock turnover than market-cap weighted indices and as a result, they are rebalanced more frequently6,7, and 2) equal-weighted indices are more volatile than market cap weighted indices due to the influence of small cap companies5.  The equal-weighted index is not calculated the same way as a price-weighted index6.

Fundamental-weighted index.  The fundamental-weighted index selects stocks based on weightings derived from data on company performance (e.g., sales, earnings), company value (e.g., book value), or shareholder reward (e.g., dividends)4,5.  The advantage of an index based on company performance is the lower likelihood of entrainment into a market “bubble” caused by momentum.  The disadvantages are that 1) the index is biased by a valuation of the company, and 2) the index incurs more turnover and higher expenses compared to the other indices 5.

Price-weighted index.  The index value is the average share price (e.g.,the Dow Jones Industrial Average).  Stocks with higher prices exert greater influence on index performance3,5,8.

Investment fund Index weighting risk

In a nearly 2-year time period, 77 ETFs changed their Index9. The danger to this move is a decline in Fund performance due to a change in index methodology.  For example, different Index providers who measure the same stock universe might use different weighting strategies, such as equal weighting versus weighting by market capitalization.  The change in weighting strategy would cause the ETF to reallocate its portfolio holdings, a move likely to affect fund performance.  One (questionable) reason for changing the index appears to be a purposeful change of portfolio holdings aimed at limiting tax consequences for the fund by maximizing capital losses and minimizing capital gains.

References

1.  Definition of ‘Index’  http://www.investopedia.com/terms/i/index.asp#ixzz1wqXHulOS

2.  Definition of ‘Weighted Average’:  http://www.investopedia.com/terms/w/weightedaverage.asp#ixzz1wf6hIDZG.

3.  Definition of ‘Weighted Average Market Capitalization’ http://www.investopedia.com/terms/w/wamc.asp#ixzz1wf7LAvtS.

4.  Rich White, 3 Types Of Indexing For ETF Success, November 23 2011, http://www.investopedia.com/articles/exchangetradedfunds/08/index-debate.asp#ixzz1wf9jnR9V

5.  Richard Shaw, Three Approaches to Index Weighting, September 15, 2008.  http://seekingalpha.com/article/95466-three-approaches-to-index-weighting

6.  Equal-weighted indices.  http://www.financialwebring.org/gummy-stuff/equal-weights.htm

7.  Definition of ‘Equal Weight’.  http://www.investopedia.com/terms/e/equalweight.asp#ixzz1wf7skCyn.

8.  ‘Price-Weighted Index’, http://www.investopedia.com/terms/p/priceweightedindex.asp#ixzz1wf5947Ly.  © 2012 Investopedia ULC.

9.  Weinberg, Ari I.  ETFs: Behind the fee cuts.  The Wall Street Journal, November 5, 2011.

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