Although capitalization-weighted indices are the most common, they’re not the only type of index out there. As I mentioned in yesterday’s post, products based on nontraditional indices can offer investors broad exposure and low costs, along with the potential to outperform the usual indices.
In an index weighted by market capitalization, the higher a company’s stock price, the greater its weight in the index. For example, if Apple doubles in price, its weight in the index doubles—and so, of course, does the index’s exposure to Apple's share price. One way to look at it is that a cap-weighted index is momentum oriented, as stocks that increase in price will be increasingly represented.
Apart from market capitalization, the other most common ways to construct an index are equal weighting and weighting by nonprice factors (fundamental weighting).
Equal weighting. In an equally weighted 500 stock index, each stock would have 1/500, or 0.2 percent, of the index. Compare this with the S&P 500, where Apple represents more than 3 percent, Exxon more than 2.5 percent, and Microsoft and other companies well over 1 percent. Unlike in an equally weighted index, these companies are vastly overweighted, and an investment in the index would be much more exposed to them.
One problem with an equal-weighted index is that smaller companies simply may not be investable in the quantities needed, driving trading costs higher. Another is that equal weighting is just as arbitrary as capitalization weighting.
Fundamental weighting. One solution is to use fundamentals, such as sales, book value, or other independent variables, as weighting factors—the idea being that larger companies will have more exposure, but not be subject to stock market momentum.
If an index is weighted on sales, for example, companies with more sales would be weighted more heavily, but that weight wouldn’t change unless the sales as compared with the rest of the index changed. In other words, you’d actually have to grow sales faster than the rest of the companies, not just get a bid on your stock.
In theory, by reducing the weight of the highest-priced stocks, fundamental indices should limit the damage caused when those stocks correct. They should also tend to buy more stocks at low prices, and fewer at high prices. That sounds good, and it has generally held true in practice: fundamental indices have tended to post better results than market-cap indices over most, but not all, time periods.
Market theorists have shown that much of the outperformance from these indices comes from a “value effect”—which makes sense, since higher-priced stocks are systematically underweighted in comparison with a cap-weighted index. The problem for investors is that attempting to invest in a value-oriented cap-weighted index would expose them to exactly the same issue, just with a different set of stocks. Trying to use a value tilt with cap weighting simply won’t yield the same results.
There are multiple ways to get the advantages of an index, including some that may provide more upside than the most popular products. Nothing is guaranteed, of course, which is why it may make sense to diversify your index exposure, just as you diversify the other areas of your portfolio.