Market value weighted indexes are also known as market cap weighted or cap weighted in market capitalization. Weighting the weight on each constituent. Security is determined by dividing its market capitalization by the total market capitalization of all the securities in the index. Market capitalization or value is calculated by multiplying the number of shares outstanding by the market price per share. So in the end, the largest companies by value have the biggest influence on the value and the overall change in the index.
The advantage of a market capitalized index is obvious. It reflects the way markets actually behave. Larger companies do, in fact have more dramatic effects on the overall market and economy than smaller companies, so it is beneficial to give them a larger weight. It's also a self rebalancing methodology in that as a company's price changes, so too do the proportions of stocks in the index basket.
The primary disadvantage is that the underlying securities whose prices have risen the most or fallen the most have a greater or lower weight in the index. This weighting method leads to overweighting stocks that have risen in price and may be overvalued and underweighting stocks that have declined in price and may be undervalued. The effect of this weighting method is similar to a momentum investment strategy, which essentially bets that near term price movement will continue. Alternative weighting schemes to cap weighting such as reverse weighting have gained more favor in recent years.
A price weighted index like the Dow Jones is simple to calculate, understand, and create. However, regardless of the issuing company's actual size or the number of shares outstanding, if one of the higher priced stocks has a huge price increase, the index is more likely to increase even if the other stocks in the index decline in value at the same time. Also, stock splits result in arbitrary changes in weights. In an equal weighted index, small companies or companies with low prices have the same impact as larger ones. Consequently, the role each index member plays in the index is simple to grasp. In addition, a large concentration of index weights over a small number of members with either very high market caps or very high prices is prevented and equal weighted indexes tend to be highly diversified. On the other hand, fund managers benchmarked against an equal weighted index must constantly rebalance their portfolios due to daily price fluctuations. As a result of this basket turnover is Much higher than in a cap weighted index, meaning that any funds tracking it will often be more expensive than comparable cap weighted ones. Fundamentally weighted index strategies screen securities in a fashion similar to that of many actively managed mutual funds, but by following a rules-based discipline based only on predefined metrics. The most important property of fundamental weighting is that it leads to indexes that have a value tilt, meaning a fundamentally weighted index has ratios of book value, earnings, dividends, et cetera, to a market value that are higher than its market capitalization weighted counterparts. Also, in contrast to the momentum effect of market capitalization, weighted indexes, fundamentally weighted indexes generally have a contrarian effect in that the portfolio weights will shift away from securities that have increased in relative value towards securities that have fallen in relative value whenever the portfolio is rebalanced. However, achieving this requires a great deal of data.
