What Is a Capitalization-Weighted Index?
A capitalization-weighted index is a type of market index where individual components of the index are included in amounts that correspond to their total market capitalization (market cap). 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.
Thus, the index components that come with a higher market cap will also carry a higher weighting in the index. At the same time, lesser-valued components will occur in the index with relatively smaller weights. A capitalization-weighted index is also known as a market value-weighted index, and can be contrasted with 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 a higher percentages 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 capitalization-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 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 Downsides 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 of a Market-Cap Weighted Index
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, 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 market cap weightings change daily with the companies' outstanding shares and their prices, which results in varying impacts on the overall Dow's value.