What Is a Capitalization-Weighted Index?
A capitalization-weighted index, also known as a market-value-weighted index, calculates weights based on each company’s total market cap (share price × number of shares outstanding). Larger corporations, by virtue of higher market caps, carry greater sway in index performance.
Free-Float Adjustment
Some indices use a free-float adjusted method, weighting stocks based only on the proportion available to public investors, excluding closely held or insider-held shares. The S&P 500, for instance, is both cap-weighted and free-float adjusted.
How Is It Calculated?
- Compute market cap for each company: Market Cap = Share Price × Shares Outstanding
- Sum all companies’ market caps to find the index’s total market cap.
- Calculate each company’s weight: Weight = Company Market Cap ÷ Total Market Cap
For example, if Company A has a market cap of $100M and total market cap is $1B, its weight is 10%.
Why Use Capitalization-Weighting?
- Reflects market consensus: Larger firms naturally have greater impact due to investor sentiment and valuations.
- Lower turnover: Minimal changes are needed unless market caps shift significantly, easing rebalancing and lowering costs.
Limitations of Cap-Weighted Indices
- Concentration risk: A few mega-cap stocks can dominate performance, leading to reduced diversification.
- Momentum bias: Rising stock prices boost weight, potentially inflating bubbles if a company becomes overvalued.
Comparison with Other Index Methods
| Index Type | Weighting Basis | Notable Examples |
| Capitalization-Weighted | Market Capitalisation | S&P 500, FTSE 100, Nasdaq |
| Price-Weighted | Share Price | DJIA, Nikkei 225 |
| Equal-Weighted | Equal for all stocks | S&P 500 Equal Weight |
| Fundamental-Weighted | Financial metrics (e.g., earnings) | Factor or dividends-based indexes |
Common Examples of Cap-Weighted Indices
Well-known indices using this method include:
- S&P 500
- Nasdaq Composite
- Wilshire 5000 (covers nearly all U.S. equities)
FAQs
Why are large companies more influential in cap-weighted indices?
Because weights are based on market capitalisation, large companies with higher market caps naturally carry more influence. A price movement in such a company affects the index disproportionately.
What is the free-float adjustment in cap-weighted indices?
Free-float adjustment considers only shares available for public trading, excluding closely held ones. This makes weightings more reflective of actual liquidity and public ownership.
How do cap-weighted indices benefit passive investors?
These indices require less frequent rebalancing, reducing trading costs and complexity. They naturally align with the market’s valuation of companies.
What is the main risk of cap-weighting?
Concentration risk is a key concern, as index returns may be overly driven by a few dominant stocks. This can result in poor diversification and vulnerability to shocks in those companies.
How does a price-weighted index differ?
A price-weighted index uses share price, not size, to determine weight. That means a high-priced stock impacts the index more, regardless of the company’s actual market value.
