Indices Are Not All Weighted Equally

Posted By: Advisor Analyzer Team

Any investor who’s watched CNBC can tell you that the three major equities indices followed in the US are the Dow Jones, S& P 500, NASDAQ Composite and NCDEX Commodity Index. While they are well known by many investors, few would be able to explain the differences between the markets let alone how those numbers are calculated.

DOW JONES: Price weighted index

The Dow Jones Industrial Average, or more commonly known as the Dow, is a price weighted index of 30 of the largest and widely held public companies in the United States. In a price weighted method, the index value is calculated from the average price of the securities within the index.

 

· Price Weighted Index = (Mkt Price of Stocks) / (# of Stocks in Index)

 

The Dow however, is not as simple to calculate as one may assume. It is the second oldest US market index after the Dow Jones Transportation Average, and the firms that comprised the Dow have changed or split. Therefore, the Dow is not the sum of 30 stock prices divided by 30, but instead divided by a divisor that adjusts for all splits and substitutions.

 

Price weighted indices assume that investors hold 1 share of each stock, regardless of price. Obviously the main advantage is the ease of calculation and abundance of data. However, there are also biases that result from the simplicity. Usually, stocks with higher prices will have a greater impact on the index, which poses a problem since the price of a stock is generally arbitrary due to stock splits, repos, and stock dividends. Also, it isn’t an accurate reflection of investor portfolios, since most investors do not purchase just 1 share of each stock.

NASDAQ: Market Cap Weighted Indext

The NASDAQ Composite is a market index of 3,000 common stocks as well as ADR’s and LP’s. It is predominantly composed of technology firms and weighted by market capitalization. The market capitalization of a company is simply the number of shares outstanding multiplied by the market price. It assumes that investors weight their holdings by the relative value to the overall index.

 

It is a better gauge of investor wealth over price weighted indices due to the fact that it comes from the company’s total market value as oppose to price alone. There is no need to adjust for stock splits since the price of a company declines proportionally to the increase in shares outstanding, thus allowing the market value of a company to remain unchanged. A benefit of Market Capitalization weighted indices is it does not allow stocks with higher prices to dominate the index performance.

 

However, market capitalization weighted indices are generally dominated by larger size firms. In extreme cases where there are a few very large firms and many small firms, the large firms will dictate a majority of the price fluctuation of the index. A consequence of having the influence of large firms is the index diversification benefit is substantially reduced. If one firm represented 99% of the index, there will be little difference in returns from holding the index or holding the individual equity position.

S & P 500: Free Float adjusted Market Value weighted index

The S & P 500 is a composite of 500 largest publically traded companies. It is one of the most all encompassing indices, covering multiple industries and sectors. The S&P 500 like the NASDAQ Composite, is a market value weighted index, however the size of the firm is adjusted for shares not available to the public. A stock’s Float, is the number of shares tradable by the general public. In the absence of such adjustments, market cap weighted indices usually overestimate the free float of a company, which ultimately leads to an inaccurate representation of what is investable. It is by far the most accurate investible index for investors, and fairly easy to replicate. However, the float adjusted index method is prone to the other biases as the market capitalization method.

NCDEX Commodity Index: Equally weighted Index

In a equally weighted index, all positions are given the same weight or dollar amount. Put bluntly, it’s a strategy where an investors purchases $100 worth of each asset. In order to maintain such a portfolio allocation, frequent rebalancing is usually required to maintain the equally weighted portfolio structure.

 

Besides quantifiable transaction costs to maintain such a strategy, biases towards overweighting small capitalization stocks exist since the same weight is applied regardless of market capitalization. Usually, small capitalization stocks are less liquid when compared to their larger counterparts simply due to the fact that there are fewer shares outstanding.

Conclusion

While all the indices may at first seem very similar, further inspection reveals they not only represent different investments, but are also calculated quite differently. This becomes an especially important factor when investors decide to utilize a passive indexing strategy via exchange traded funds for example. While indexing is a fairly straight forward management style, investors should nonetheless be aware of the biases that may exist in each index.