What Is a Capitalization-Weighted Index?
A capitalization-weighted index is a type of stock market index where individual components of the index are included in amounts that correspond to their total market capitalization (shortened as "market cap"). A company's market capitalization is calculated by multiplying its outstanding shares by the current price of a single share. (Outstanding shares are those owned by individual shareholders, institutional block holdings, and company insider holdings.) In this way, market capitalization reflects the total market value of a firm's outstanding shares. A capitalization-weighted index is also known as a market value-weighted index
A stock market index measures a subset of the stock market and helps investors compare current price levels with past prices in order to glean information about the current market performance. The three major U.S. stock indexes are the Nasdaq Composite Index (IXIC), the Dow Jones Industrial Average, and Standard and Poor's (S&P) 500 Index. An index is computed using various methods (including the capitalization-weighted method) with the prices of selected stocks.
With the capitalization-weighted method, the index components with a higher market cap will receive a higher weighting in the index. Proportionally, the performance of companies with a small market cap will have less of an impact on the performance of the overall index. Other methods for computing the value of stock market indexes are the price-weighted, fundamental-weighted, and equal-weighted index construction methods.
- A capitalization-weighted index is an index construction methodology where individual components are weighted according to their relative total market capitalization.
- The components with higher market caps carry greater percentage weights in the index. Conversely, the components with smaller market caps have lower weightings in the index.
- Critics of cap-weighted indices argue that the overweighting toward larger companies gives a distorted view of the market.
Understanding Capitalization-Weighted Indices
Many stock market indexes are capitalization-weighted indexes, including the S&P 500 Index, the Wilshire 5000 Total Market Index (TMWX), and the Nasdaq Composite Index (IXIC). Market-cap indexes provide investors with information about a wide variety of companies—both large and small.
A capitalization-weighted index uses a company's market capitalization to determine how much impact that particular security can have on the overall index results. Market capitalization is derived from the value of outstanding shares. The investment community can use market capitalization to determine a company's size, as opposed to using sales or total asset figures.
In the composition of a capitalization-weighted index, large movements in the price of shares 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 also 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 capitalization-weighted indexes might argue that the overweighting of the largest companies can 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 capitalization-weighted index, first 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—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.
Advantages and Disadvantages of Capitalization-Weighted Indexes
Many of the world's most popular benchmark indexes are market cap-weighted, making them easily accessible to most investors to gain access to a well-diversified, broad-based portfolio. Over time, however, if certain companies grow enough, they can end up making up an excessive amount of the weighting in an index. This is because, as a company grows, index designers are obligated to appoint a greater percentage of the company to the index. These companies tend to be less volatile, more mature, and better suited for most investors as core holdings. At the same time, this effect can endanger a diversified index by placing too much weight on one individual stock's performance as it comes to dominate the index make-up.
In addition, index funds and 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, these funds purchase more shares at the higher prices; this can be counterintuitive to the investing mantra of buying low and selling high.
If a company's stock is fundamentally overvalued (from a technical analysis standpoint), the purchasing of the stock as its price (and thus, its market cap) 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. If the bubble were to burst, this would send stock prices into a 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 lower volatility to investors
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
Example of a Capitalization-Weighted Index
The S&P 500 is a capitalization-weighted index that contains some of the most well-established companies in the U.S. The following is a historical real example of how the index functioned on a particular trading day:
- On April 22, 2019, 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 weightings of the S&P 500 change daily with the companies' outstanding shares and their prices, which results in varying impacts on the Index's overall value.