Market Capitalization Weighted Index
Over time, traditional market-cap weighted indexes such as the S&P 500 and the Russell 1000 have been shown to outperform most active managers. However, market cap weighted indexes suffer from a systematic flaw. The problem is that market-cap weighted indexes increase the amount they own of a particular company as that company's stock price increases. As a company's stock falls, its market capitalization falls and a market cap-weighted index will automatically own less of that company.
However, over the short term, stock prices can often be affected by emotion, resulting in some stocks being overpriced and some stocks being priced too cheaply. A market index that bases its investment weights solely on market capitalization (and therefore market price) will systematically concentrate too much weight in stocks when they are overpriced and too little in stocks when they are priced at bargain levels. (In the internet bubble, for example, as internet stocks went up in price, market cap-weighted indexes became too heavily concentrated in this overpriced sector and too underweighted in the stocks of established companies in less exciting industries.) This systematic flaw appears to cost market cap-weighted indexes approximately 2% per year in return over long periods.
Advantages
- The total return of the index roughly mirrors the change in the total market value of all stocks.
- Rebalancing this type of index is simple.
- Since the index automatically adjusts to changes in stock prices, it is easy to create a tax efficient mutual fund or ETF to track this type of index.
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Disadvantages
- If stock prices reflect emotions over the short term, then the index will systematically own too much of overpriced stocks and too little of bargain priced stocks.
- The index is heavily influenced by the few companies with the largest market capitalizations. For instance, the top 20 stocks in the S&P 500 index can account for one-third of the total index.
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How to Calculate
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ASSUME THE STOCK MARKET HAS ONLY THREE COMPANIES: |
| |
Market
Capitalization |
|
Last Year's
Earnings |
| Company A = |
$6 billion |
|
$100 million |
| Company B = |
$3 billion |
|
$300 million |
| Company C = |
$1 billion |
|
$200 million |
Total Market Cap
of All Companies |
$10 billion |
Total Earnings
of All Companies |
$600 million |
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MARKET CAP WEIGHTED INDEX |
| Company A = |
$6 billion |
= 60% weight in index |
| $10 billion |
| Company B = |
$3 billion |
= 30% weight in index |
| $10 billion |
| Company C = |
$1 billion |
= 10% weight in index |
| $10 billion |
| The market-cap-weighted index, as the name implies, weights companies according
to market cap. Here, Company A has a market capitalization of $6 billion
which is equal to 60% of the total market cap of all stocks ($10 billion). |
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Examples
- iShares Russell 1000 Index – (ETF symbol: IWB)
The ETF employs an indexing investment approach to track the performance of the Russell 1000 Index, a widely recognized benchmark of U.S. stock market performance that is dominated by the stocks of large U.S. companies representing approximately 90% of the market capitalization of all publicly-traded U.S equity securities. The ETF attempts to replicate the target index by investing all, or substantially all, of its assets in the stocks that make up the Index, holding each stock in approximately the same proportion as its weighting in the Index.
- iShares Russell 2000 Index – (ETF symbol: IWM)
The ETF employs an indexing investment approach to track the performance of the Russell 2000 Index, a widely recognized benchmark of U.S. stock market performance that approximately represents the stocks of U.S. companies with market capitalizations from between the 1001st largest U.S. listed company and the 3000th largest U.S. listed company. These stocks represent about 7% of the overall U.S. market. The ETF attempts to replicate the target index by investing all, or substantially all, of its assets in the stocks that make up the Index, holding each stock in approximately the same proportion as its weighting in the Index.
- iShares MSCI EAFE Index – (ETF symbol: EFA)
The ETF employs an indexing investment approach to track the performance of the MSCI® EAFE Index, which includes stocks from Europe, Australasia and the Far East and, as of September 30, 2010, consisted of the following 22 developed market country indexes: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the United Kingdom. The Fund holds approximately 950 stocks in a broadly diversified collection of securities that, in the aggregate, approximates the full Index in terms of key characteristics.
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