What Is a Capped Index?
A capped index is an equity index that has an upper limit on the weight of any single security. Thus, a capped index sets a maximum percentage on the relative weighting of a component that is determined by its market capitalization, even if that company naturally carries a greater weight in the market. The rationale behind a capped index is to prevent any single security from exerting a disproportionate influence on an index.
- A capped index puts a limit on the weight of any single security in an equity index.
- A capped index prevents very large companies from exerting an overly large influence on the index as they grow bigger and bigger.
- Often, the weight of each component will be based on its float-adjusted market cap, but is modified such that no stock has a weight over X% of the whole index.
Understanding Capped Indexes
If a market index becomes too concentrated in a small handful of stocks, it can distort the diversification benefits of a broad index and lead to the index being driven almost entirely by those very large components. Putting a cap in place restricts this influence, by mandating that, say, no more than 10% of the index be weighted to any single company regardless of its true size.
Some capped indexes employ market capitalization to determine where each constituent in the index is weighted by its free float-adjusted market capitalization. Applying free float-adjusted market capitalization weighting may result in certain cases in large sector, geographical or company concentration. Capped indexes are often seen as an alternative to purely free float-adjusted market capitalization weighted indices by constraining the maximum sector, geographical or constituent weights. This is a self-rebalancing methodology, in that as a company’s price or outstanding share quantity changes, so do the proportions of stocks in the index.
One disadvantage of a cap-weighted index is that it does not always accurately reflect the way markets actually behave: Larger companies do, in fact, have greater influence on the overall market than smaller companies. Market cap-weighted schemes aren’t perfect. Sometimes companies have shares that aren’t fully available for trade on the open market (such as government-held shares, or large privately-controlled holdings). In such cases, pure cap-weighted schemes would misrepresent the actual investable market cap available.
Capped Index Guidelines
In some instances, the calculation of the constituent capping factors are based on prices at market close on the second Friday of the review month, using shares in issue and investability weights as designated to take effect after close on the third Friday of the review month (i.e. taking effect on the review effective date).
Calculation of capping factors should take into account any corporate actions/events that take effect after close on the second Friday of the review month up to and including the review effective date, if they have been announced and confirmed by the second Friday of the review month.
Corporate actions and events announced after the second Friday of the review month that become effective up and including the review effective date will not result in any further adjustment.
Example of a Capped Index
For example, in Canada, the S&P/TSX Capped Composite index that is maintained by Standard & Poor's restricts the weighting of any component to a maximum of 10 percent, regardless of its market capitalization. The S&P/TSX Capped Composite index was introduced in 2002, subsequent to the rise and fall of Nortel Networks, which at its peak accounted for almost one-third of the total market capitalization of all stocks on the former TSX-300 index.