What Differences Do Weighting Schemes Really Make?

Weighting schemes can be a major determinant of investment outcomes, not just on returns but also risk and, crucially, drawdowns. Such differences can persist over years across all major indices; for example, the Nasdaq 100 Index was flat in 2018 but the Nasdaq 100 Equal Weight Index was down almost 5% that year, despite having exactly the same stocks.

Market capitalization weighting is used by all the major benchmark indices (more of which later), which is useful for obtaining cheap, broad market exposure with large capacity. Benchmark indices are the base case, the bread and butter. If you have more specific investment goals, there is a variety of indices calculated with different weighting schemes that can deliver different returns. At The Index Standard, we believe investors should have a fair understanding of how weighting schemes can affect indices before making any purchase decisions. We also display the weighting scheme of every index in our ratings.

The Weighting Schemes

Market Capitalization

This is the most widely used weighting scheme, in which stocks are weighted by their market capitalization (equity value). The bigger the company, the more weight it will be given in the index, as determined by its equity value divided by the total value of all the constituents.

For example, if Microsoft’s market cap was $2 trillion on a rebalancing date of the S&P 500, and the sum of all constituents’ market caps was $40 trillion, then Microsoft’s weight on the index would be: $2 trillion / $40 trillion = 5%.

Note that an index calculator will frequently use a free-float market cap measure. Free-float is the amount of equity that trades freely and is not held by, say, the company’s founder(s).

The major advantage of market cap weighting is that large sizes can be traded easily and cheaply with minimal market impact. This is because the largest stocks are typically the most liquid and with the most volume, and trading them in proportion to their size easily facilities this.

The main disadvantage, however, is that the largest stocks are usually mature companies with slower growth than the smaller stocks. A purchaser is buying high in the hope that the share price will continue to appreciate so they can sell at an even higher level later. While the past few years have been a rare case in which corporate giants such as Alphabet, Amazon and Microsoft have grown even bigger, historically large-caps have grown more slowly than small-caps.

Another shortcoming of market cap weighting is that it tends to make indices very top heavy since the largest stocks will inevitably dominate. The top 10 stocks in the Nasdaq 100 Index, for instance, account for over 50% of the index as of H2 2021.

Modified Market Capitalization

Modified-market-cap indices are very similar to market-cap indices with one significant (but positive) difference: they cap the weight of the largest stocks with a fixed limit. Many sector indices are capped to avoid larger stocks from dominating.

As an example, in a typical energy index ExxonMobil could account for over 20% if uncapped, which is clearly a substantial number. However, in a capped index ExxonMobil could be limited to 5% or 10%, thus creating a better balance between the index constituents while still allowing easy, low-cost trading.

Equal Weighting

In an equal weighting scheme, each stock is allocated the same weight. For example, in an index with 100 stocks, each stock will get a 1% weight (100% of the index weight/100 = 1%). Using Microsoft as an example again, in the S&P500 Equal Weight Index the company only has a weight of 0.2%, vs. 5% in the market-cap-weighted S&P 500 Index.

The merit of equal weighting is that it gives investors the same allocation to all of the index components. In an equity index, for example, it allows more exposure to smaller, typically faster growing stocks. The risk is higher, but so is the opportunity for a higher return. But this comes at a cost. With all stocks having an equal exposure, a large buy order (in the billions) would cost more to execute. This is because the bid/offer spreads are wider on smaller stocks and large buy orders can cause the price to rise, to the detriment of investors, who will want the price to rise only after purchasing the stocks.

Fundamental Weighting

An increasingly popular methodology is the fundamental index, in which stocks are selected based on their financial factors such as profit, dividends, sales, price to earnings, to name a few. The theory is that stocks with robust fundamentals should perform better in the long run, just as you’d expect someone healthy to live longer.

Some fundamental indices include a combination of metrics. The index provider may score individual elements of a stock, then add up the total score to determine its weight.

Factor indices are another type of fundamental index which focus on investment factors typically backed by academic research. A popular one is low volatility, whereby the index designer will measure the stocks’ respective price fluctuations (usually over the last 12 months) and put the most weight on those with the lowest volatility, and vice versa. The aim is to design a stocks basket that has lower fluctuations than the market and is more likely to have lower drawdowns.

Dividend yield weighting is another example. Dividend yield is the measure of dividend paid out divided by stock price. The stock with the highest dividend (or projected dividend) will carry the largest weight, which attempts to increase the overall dividend yield of the index.

Risk Weighting

Risk weighting and risk parity are schemes which weight stocks by - you guessed it - risk. Typically used in multi-asset baskets, this approach adjusts the weight of each asset by its risk profile which will result in all of the constituents having the same level of risk. Sometimes, the only risk measure used is volatility, and this can be called “inverse volatility”. If the level of risk, returns and the correlations are considered in an optimization to reduce risk, it’s called a mean variance portfolio. If one assumes the Sharpe ratio is equal, it’s a risk parity portfolio. The objective of these schemes is to produce defensive indices with higher Sharpe ratios and lower drawdowns compared to traditional benchmarks.

Some indices overlay a target volatility mechanism to attain a consistent level of volatility of the portfolio and drawdowns. This technique is now commonly used in structured products or fixed-index annuities (FIA). For more information, see our guide on Volatility Control Indices.

Pricing Weighting

In the price weighting scheme, index constituents are represented by their stock price - the higher the stock price, the larger the weight. It is a flawed concept and lacks economic rationale, which explains why it is now rarely used except for one remaining dinosaur: the Dow Jones Industrial Average. The index was developed over 100 years ago and, well, has not been updated. Compared to the other benchmark indices, the Dow Jones Industrial Average neither represents today’s broad market nor provides a balanced exposure. We would advise our readers to consider other more diversified alternatives.

So, What’s The Best?

There is no definite answer and, like many other choices we make, it depends on your end goals. We at The Index Standard like well-balanced and diversified indices with no major overweights to individual stocks, countries or sectors. We also like to use factor indices as a complement to market-cap-weighted indices, primarily to offset some of the latter’s disadvantages as we previously noted.