What is a Capitalization-Weighted Index
A capitalization-weighted index is a type of market index with individual components that are weighted according to their total market capitalization. The larger components carry higher percentage weightings, while the smaller components in the index have lower weights. This type of index is also known as a market value-weighted index.
BREAKING DOWN Capitalization-Weighted Index
Most of the broadly used market indexes today are cap-weighted indexes, such as the Standard and Poor's (S&P) 500 Index, the Nasdaq Composite Index, the Wilshire 5000 Total Market Index, the Hang Seng Index and the MSCI EAFE Index. In a cap-weighted index, large price moves in the largest components can have a dramatic effect on the value of the index. Some investors feel that this overweighting toward the larger companies gives a distorted view of the market, but the fact that the largest companies also have the largest shareholder bases makes the case for having the higher relevancy in the index.
Capitalization-Weighted Index Calculation Example
To find the value of a cap-weighted index, an analyst should multiply each constituent's market price by its total outstanding shares to arrive at the total market value. Then, the proportion of this value to the overall total market value of all the index components gives the weight of the company in the index. For example, consider the following five companies:
Company A: 1 million shares outstanding, current price per share equals $45
Company B: 300,000 shares outstanding, current price per share equals $125
Company C: 500,000 shares outstanding, current price per share equals $60
Company D: 1.5 million shares outstanding, current price per share equals $75
Company E: 1.5 million shares outstanding, 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
This means that the entire market value of all the index components equals $232.5 million, giving Company A a weight of 19.4%, Company B a weight of 16.1%, Company C a weight of 12.9%, Company D a weight of 48.4% and Company E a weight of 3.2%. Even though the final two companies have equal amounts of shares outstanding, they are actually the highest and lowest weighted companies in the index because of the effects of their prices on their individual market values.
In practice, an index divisor is calculated to make reporting of the index level easier and more manageable. In this example, on day one of the index, a likely index divisor would be $232,500. This would give the index an initial value of $232,500,000 / $232,500 = 1,000.
Downside of Capitalization-Weighted Indexes
Certain companies can grow to the point that they take up an inordinate amount of space in an index. As a company grows, index designers are obligated to appoint a greater percentage of the company to the index. This can endanger a diversified index by placing too much weight on one individual stock's performance. In addition, index funds buy more of the stock as its market capitalization increases, meaning its share price has gone up. This goes against the traditional investing mantra of buying at low rather than high prices.
Moreover, as index funds proliferate, their collective purchasing decisions can have a dramatic affect on a stock's price, as they buy more the more a stock goes up. This can lead to stock market bubbles and, subsequently, bursts.