Capitalization-Weighted Index Explained

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Capitalization-Weighted Index

In a capitalization-weighted index, each component stock contributes its market value to determine the overall index value and, therefore, stocks with greater market value are given more weight in this type of index.

Calculating the Index Value

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. This divisor is an arbitrary number that is first defined when the index is first published.

Example

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

Company Stock Price Shares Outstanding Market Cap Weightage
Company A $30 1,000,000 $30,000,000 25%
Company B $60 500,000 $30,000,000 25%
Company C $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

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Capitalization-Weighted Index

What Is a Capitalization-Weighted Index?

A capitalization-weighted index is a type of market index with individual components, or securities, weighted according to their total market capitalization. Market capitalization uses the total market value of a firm’s outstanding shares. The calculation multiples outstand shares by the current price of a single share. Outstanding shares are those owned by individual shareholders, institutional block holdings, and company insider holdings.

The components with a higher market cap carry a higher weighting percentage in the index. Conversely, the components with smaller market caps have lower weightings in the index. A capitalization-weighted index is also known as a market value-weighted index.

Capitalization-Weighted Index

Key Takeaways

  • A capitalization-weighted index is a type of market index with individual components that are weighted according to their total market capitalization.
  • The components with a higher market cap carry a higher weighting percentage in the index. Conversely, the components with smaller market caps have lower weightings in the index.
  • Critics of cap-weighted indices might argue that the overweighting toward larger companies give a distorted view of the market.

Understanding Capitalization-Weighted Indices

Most stock market indexes are cap-weighted indexes, including the Standard and Poor’s (S&P) 500 Index, the Wilshire 5000 Total Market Index (TMWX) and the Nasdaq Composite Index (IXIC). Market-cap indexes provide investors with access to a wide a variety of companies both large and small.

The capitalization-weighted index uses a stock’s market capitalization to determine how much impact that particular security can have on the overall index results. As mentioned earlier, market capitalization, or market cap, comes from the value of outstanding shares. The investment community uses this figure to determine a company’s size, as opposed to using sales or total asset figures.

As a result, in the makeup or composition of a cap-weighted index, large movements in share value for the largest index companies can significantly impact the value of the overall index. However, since large companies with numerous outstanding shares tend to be more stable revenue producers, they can provide steady growth for the index. On the other hand, small companies tend to have a lower weighting, which can reduce risk if the companies don’t perform well.

Critics of the cap-weighted indices might argue that the overweighting toward the larger companies give a distorted view of the market. However, the largest companies also have the largest shareholder bases, which makes a case for having a higher weighting in the index.

Calculation of a Capitalization-Weighted Index

To find the value of a cap-weighted index, we can multiply each component’s market price by its total outstanding shares to arrive at the total market value. The proportion of the stock’s value to the overall total market value of the index components provides the weighting of the company in the index. For example, consider the following five companies:

  • Company A: 1 million shares outstanding, the current price per share equals $45
  • Company B: 300,000 shares outstanding, the current price per share equals $125
  • Company C: 500,000 shares outstanding, the current price per share equals $60
  • Company D: 1.5 million shares outstanding, the current price per share equals $75
  • Company E: 1.5 million shares outstanding, the current price per share equals $5

The total market value of each company would be calculated as:

  • Company A market value = (1,000,000 x $45) = $45,000,000
  • Company B market value = (300,000 x $125) = $37,500,000
  • Company C market value = (500,000 x $60) = $30,000,000
  • Company D market value = (1,500,000 x $75) = $112,500,000
  • Company E market value = (1,500,000 x $5) = $7,500,000

The entire market value of the index components equals $232.5 million with the following weightings for each company:

  • Company A has a weight of 19.4% ($45,000,000 / $232.5 million)
  • Company B has a weight of 16.1% ($37,500,000 / $232.5 million)
  • Company C has a weight of 12.9% ($30,000,000 / $232.5 million)
  • Company D has a weight of 48.4% ($112,500,000 / $232.5 million)
  • Company E has a weight of 3.2% ($7,500,000 / $232.5 million)

Although companies D and E have equal amounts of shares outstanding at 1,500,000, they represent the highest and lowest weightings in the index, respectively, because of the effects of their prices on their individual market values.

The Downside of Capitalization-Weighted Indexes

Over time, companies can grow to the extent that they make up an excessive amount of the weighting in an index. As a company grows, index designers are obligated to appoint a greater percentage of the company to the index, which can endanger a diversified index by placing too much weight on one individual stock’s performance.

Also, index funds or exchange-traded funds buy additional shares of a stock as its market capitalization increases or as the share price increases. In other words, as the stock price is rising, the funds are purchasing more shares at the higher prices, which can be counterintuitive to the investing mantra of buying low and selling high.

If a company’s stock is overvalued from a fundamental standpoint, the purchasing of the stock as its market-cap and price increases can create a bubble in the stock’s price. As a result, purchasing stocks based on market-cap weightings can lead to a stock market bubble and increase the risk of the bubble bursting sending stock prices into free fall.

Market-cap indexes provide investors with access to a wide a variety of companies both large and small

Large well-established companies have a greater weighting providing steady growth for the index

Small companies tend to have a lower weighting, which can reduce risk if the companies don’t survive

As a stock price rises, a company can have an excessive amount of the weighting in an index

Companies with larger weightings can have a disproportionate impact on the fund’s performance

Fund managers can often add shares of overvalued stocks assigning a larger weighting and create a bubble

Real-World Example

The S&P is a market-cap weighted index containing some of the most well-established companies in the U.S.

  • As of March 22, 2020, Boeing Co. (BA) closed down -2.83% to $362.17 while Microsoft Corp. (MSFT) closed down -2.64% to $117.05 for the day.
  • Boeing had a market cap of $209 billion and a weighting of less than 1% in the S&P on that day.
  • Microsoft Corp. had a market cap of $909 billion and a weighting of over 3% in the S&P.
  • As a result, Boeing’s price decline had a smaller impact on the S&P than Microsoft’s impact even though both stocks declined by nearly the same percentage.
  • In other words, Microsoft dragged the S&P down more so than Boeing for that day because Microsoft had a larger market cap than Boeing.

It’s important to note that the market cap weightings change daily with the companies’ outstanding shares and their prices, which results in varying impacts on the overall Dow’s value.

An Introduction to U.S. Stock Market Indexes

Stock market indexes around the world are powerful indicators for global and country-specific economies. In the United States the S&P 500, Dow Jones Industrial Average, and Nasdaq Composite are the three most broadly followed indexes by both the media and investors. In addition to these three indexes there are approximately 5,000 others that make up the U.S. equity market.

With so many indexes, the U.S. market has a wide range of methodologies and categorizations that can serve a broad range of purposes. The media most often reports on the direction of the top three indexes regularly throughout the day with key news items serving as contributors and detractors. Investment managers use indexes as benchmarks for performance reporting. Meanwhile, investors of all types use indexes as performance proxies and allocation guides. Indexes also form the basis for passive index investing often done primarily through exchange-traded funds that track indexes specifically.

Overall, an understanding of how market indexes are constructed and utilized can help to add meaning and clarity for a wide variety of investing avenues. Below we elaborate on the three most followed U.S. indexes, the Wilshire 5000 which includes all the stocks across the entire U.S. stock market, and a roundup of some of the other most notable indexes.

Key Takeaways

  • There are approximately 5,000 U.S. indexes.
  • The three most widely followed indexes in the U.S. are the S&P 500, Dow Jones Industrial Average, and Nasdaq Composite.
  • The Wilshire 5000 includes all the stocks from the U.S. stock market.
  • Indexes can be constructed in a wide variety of ways but they are commonly identified generally by capitalization and sector segregation.

Index

The S&P 500

The Standard & Poor’s 500 Index (known commonly as the S&P 500) is an index with 500 of the top companies in the U.S. Stocks are chosen for the index primarily by capitalization but the constituent committee also considers other factors including liquidity, public float, sector classification, financial viability, and trading history. The S&P 500 Index represents approximately 80% of the total value of the U.S. stock market. In general, the S&P 500 Index gives a good indication of movement in the U.S. market as a whole.

Indexes are usually market weighted or price weighted. The S&P 500 Index is a market weighted index (also referred to as capitalization weighted). Therefore, every stock in the index is represented in proportion to its total market capitalization. In other words, if the total market value of all 500 companies in the S&P 500 drops by 10%, the value of the index also drops by 10%.

The Dow Jones Industrial Average

The Dow Jones Industrial Average (DJIA) is one of the oldest, most well-known, and most frequently used indexes in the world. It includes the stocks of 30 of the largest and most influential companies in the United States. The DJIA is a price-weighted index. It was originally computed by totaling the per-share price of the stocks of each company in the index and dividing this sum by the number of companies. Unfortunately, the index is no longer this simple to calculate. Over the years, stock splits, spin-offs, and other events have resulted in changes in the divisor (a numerical value computed by Dow Jones used to calculate the level of the DJIA) making it a very small number (less than 0.2).

The DJIA represents about a quarter of the value of the entire U.S. stock market, but a percent change in the Dow should not be interpreted as a definite indication that the entire market has dropped by the same percent. This is because of the Dow’s price-weighted function. The basic problem is that a $1 change in the price of a $120 stock in the index will have a greater effect on the DJIA than a $1 change in the price of a $20 stock, although the higher-priced stock may have changed by only 0.8% and the other by 5%.

A change in the Dow represents changes in investors’ expectations of the earnings and risks of the large companies included in the index. Because the general attitude toward large-cap stocks often differs from the attitude toward small-cap stocks, international stocks, or technology stocks, the Dow should not be used to represent sentiment in other areas of the marketplace. In general, the Dow is known for its listing of the U.S. markets best blue-chip companies with regularly consistent dividends. Therefore, while not necessarily a representation of the broad market, it can be a representation of the blue-chip, dividend-value market.

The Nasdaq Composite Index

Most investors know that the Nasdaq is the exchange on which technology stocks are traded. The Nasdaq Composite Index is a market-capitalization-weighted index of all the stocks traded on the Nasdaq stock exchange. This index includes some companies that are not based in the United States.

Known for being heavily tech weighted, this index includes several subsectors across the tech market including software, biotech, semiconductors, and more. Although this index is known for its large portion of technology stocks, it does include some securities from other industries as well. Investors will also find securities from a variety of sectors as well, including financials, industrials, insurance, and transportation stocks, among others. The Nasdaq Composite includes large and small firms, but unlike the Dow and the S&P 500, it also includes many speculative companies with small market capitalizations. Consequently, its movement generally indicates the performance of the technology industry as well as investors’ attitudes toward more speculative stocks.

The Wilshire 5000

The Wilshire 5000 is sometimes called the “total stock market index” or “total market index” because it includes all of the publicly traded companies with headquarters in the United States that have readily available price data. Finalized in 1974, this index represents the entire U.S. stock market and its movement aggregately. Although it is a very comprehensive measure of the entire U.S. market, the Wilshire 5000 is referred to less often than the more popular S&P 500 Index.

A Roundup of Other U.S. Indexes

Generally, there are a few ways to look at indexes broadly. Capitalization is often key, with indexes falling into either large-, mid-, or small-cap buckets. The S&P 500 and Dow Jones Industrial Average are two of the top large-cap indexes, but others include the S&P 100, the Dow Jones U.S. Large-Cap Total Stock Market Index, the MSCI USA Large-Cap Index, and the Russell 1000. Notable mid-cap indexes include the S&P Mid-Cap 400, the Russell Midcap, and the Wilshire US Mid-Cap Index. In small-caps, the Russell 2000 is an index of the 2,000 smallest stocks from the Russell 3000. Other popular small-cap indexes include the S&P 600, the Dow Jones Small-Cap Growth Total Stock Market Index, and the Dow Jones Small-Cap Value Total Stock Market Index.

Investors also commonly look to sectors with Standard & Poor’s leading in this realm of the market. Standard & Poor’s manages: the S&P Communication Services Select Sector, S&P Consumer Discretionary Select Sector, S&P Consumer Staples Select Sector, S&P Energy Select Sector, S&P Financial Select Sector, S&P Health Care Select Sector, S&P Industrial Select Sector, S&P Materials Select Sector, S&P Real Estate Select Sector, S&P Technology Select Sector, and the S&P Utilities Select Sector. These indexes represent the S&P 500’s comprehensive sector segregations.

The growth of smart beta index investing has also helped to increase the number of indexes in the market. Smart beta indexes are passive indexes that are built using certain characteristic or fundamental screens that help to improve the quality of index constitution. Advisors Asset Management (AAM) has three smart beta index funds in the market that largely encompass the entire global market for dividend and value investing. AAM’s smart beta index funds include the AAM S&P 500 High Dividend Value ETF (SPDV), the AAM S&P Developed Markets High Dividend Value ETF (DMDV), and the AAM S&P Emerging Markets High Dividend Value ETF (EEMD).

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