Market Cap-Weighted Index
Published on :
21 Aug, 2024
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Dheeraj Vaidya
What Is A Market Cap-Weighted Index?
A Market Cap-Weighted Index is a form of stock market index where each element is assigned a weight that is associated with the total market capitalization. This index is employed as a tool to measure the size and worth of a publicly traded company.
A company's valuation in this index determines the level of impact its stock prices have on the index performance. As a result, a company with a larger market capitalization has a more significant influence on this index's performance. Conversely, companies with lesser market capitalization do not have a significant impact on the total index.
Table of contents
- A Market Cap-Weighted Index represents one of the most common stock market index types, where the weight of an individual stock is allocated based on its total market capitalization.
- This index aids in the study of the market's collective response to the relative value of each stock.
- These indexes enable investors to construct a diverse portfolio. A well-diversified portfolio reduces market risk and enhances returns.
- A higher stock price offers a company greater significance in the index. It can cause an unfavorable balance in the index.
Market Cap-Weighted Index Explained
A Market Cap-Weighted Index is a type of stock market index where every component of this index has a weight assigned to it based on the overall market capitalization. This index is used to assess the size and value of an entity that is publicly traded.
In this index, the market capitalization value of a company regulates the level of impact the price of its shares has on the market index's performance. Consequently, a company with a higher market capitalization has a more significant impact on the performance of this index. On the other hand, businesses with smaller market capitalizations have minimal impact on the index performance.
These indexes offer investors information about large-cap and small-cap companies. It is one of the most commonly used indexes. However, they may provide a distorted perception of the market performance and may fail to capture the outperformance of smaller companies adequately.
Formula
The market capitalization can be calculated using the following formula:
Market Capitalization = Share Price x Outstanding Shares
The weight of each index constituent is calculated by:
Weight = Market Capitalization of each constituent / Total Capitalization of index market x 100%
Examples
Let us understand the concept with the help of the following examples:
Example #1
Given below are the data of 3 imaginary companies:
| Company Name | Share Price (in $) | Outstanding Shares |
|---|---|---|
| Roxy Ltd. | 10 | 100,000 |
| Jack’s Haven | 20 | 150,000 |
| Maple Softwares | 5 | 120,000 |
Therefore, the market capitalization of each company is as follows:
| Company Name | Market Capitalization Calculation | Market Capitalization (in $) |
|---|---|---|
| Roxy Ltd. | 10 x 100,000 | 1,000,000 |
| Jack’s Haven | 20 x 150,000 | 3,000,000 |
| Maple Softwares | 5 x 120,000 | 600,000 |
Total Capitalization of index market = $1,000,000 + $3,000,000 + $600,000 = $4,600,000
Finally, the market capitalization of each constituent is as follows:
| Company Name | Weight | Market capitalization of each constituent |
|---|---|---|
| Roxy Ltd. | 1,000,000 / 4,600,000 x 100% | 22% |
| Jack’s Haven | 3,000,000 / 4,600,000 x 100% | 65% |
| Maple Softwares | 600,000 / 4,600,000 x 100% | 13% |
Example #2
In July 2023, the NASDAQ-100 was going through a special readjustment. This index tracks the 100 most significant non-financial assets on the Nasdaq Stock Exchange. It primarily comprises technology stock but also includes other industries. In 2023, the Nasdaq-100 increased by over 42%. However, this scenario created specific issues that led the index to announce a special reallocation. The significant profits for the top few businesses made the index substantially top-heavy and unbalanced than the desired levels. The top five companies alone accounted for over 43% of the index.
Advantages And Disadvantages
Some advantages of the index include the following:
- This index helps study the market's collective reactions to each stock's relative worth.
- They allow investors to construct a diversified portfolio. A diverse portfolio helps maximize profits while minimizing market risk.
- The significantly large and well-established businesses have a greater weighting in these indexes. They offer stability to the investors and the indexes as they are not very volatile to market changes.
- Assets tracking these indexes have less turnover and associated trading expenses.
The disadvantages are:
- With rising stock prices, a company gains excess weighting in the index. It may lead to an imbalance in the index, which is not preferable.
- Businesses with larger weights may have an unreasonable impact on the asset's performance in the market.
- The fund managers may introduce the shares of overvalued assets, which may create a bubble in the stock prices, eventually leading to a stock market bubble.
Market Cap-Weighted Index vs Price-Weighted Index vs Equal-Weighted Index
The differences between the three are as follows:
Market Cap-Weighted Index
- In this type of stock market index, the weight of a specific stock is established from its total market capitalization. It is one of the most common stock market index types.
- Companies with larger market capitalization gain a higher weightage, which results in a change in their stock prices that significantly impacts index performance. Companies with smaller market capitalization have a lesser impact on the total index.
- This index is not equipped to measure the outperformance of stocks with smaller market capitalization.
Price-Weighted Index
- A price-weighted Index is a stock market index type where each constituting asset is assigned a weight that is proportional to its price per share.
- In this index, companies with higher asset prices have more impact on the performance of the index as compared to businesses with lower asset prices.
- This index fails to accurately reflect the overall performance of particular sectors in the market as the weight is based on the stock price and not the size of the business or its number of outstanding shares.
Equal-Weighted Index
- An equal-weighted index is a type of stock market index that assigns an equal amount of money to the asset of each company comprising the index.
- It consists of a group of publicly traded companies, where the market performance of each company's assets contributes equally to the total index value.
- These indexes provide equal importance to smaller companies as well as large, well-established ones. This index is unbiased in relation to market capitalization.
Frequently Asked Questions (FAQs)
In this index, the company valuation impacts the index value as companies with a more significant market capitalization have a higher influence on the index value. Such companies carry more weight and can affect the entire index fund as compared to companies with smaller market capitalization.
The Standard and Poor's 500 Index, also known as the S&P 500 Index, falls under this index category. It comprises 500 prominent publicly traded companies in the United States. It was established in January 1993, and it assigns a percentage weight to each constituent based on the total equity market's value.
The Dow Jones Industrial Average (DIJA) or Dow Jones Index is a stock market index of 30 leading companies that comes under the stock exchanges in the United States. However, it is a price-weighted index that uses market capitalization. It was first calculated on May 26, 1896, and is the second oldest among all indices in the US. The index was founded by Charles Dow and named after him and his business associate, Edward Jones.
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