Question

3. Explain the difference between a price-weighted index and market-weighted index. Is the Dow-Jones considered a price-weighted or market-weighted index?

Answer 1

DOW JONES USES PRICE WEIGHTING

index’s selection methodology can only tell you so much about how it will perform over time. Often its real secret sauce is how its securities are weighted within the basket.

The price-weighted index

Price-weighted indexes aren’t particularly common anymore. Still, one of the world’s most widely tracked indexes – the Dow Jones Industrial Average – uses price weighting, so the process is worth understanding.

A price-weighted index is one which includes an equal number of shares for each security in its basket – meaning the higher a security’s price goes, the more it will drive the index’s overall value.

For example, let’s look at a hypothetical five member price-weighted index basket:

SECURITY	PRICE	SHARE	WEIGHTING
A	$3	10	10%
B	$1	10	3%
C	$7	10	23%
D	$9	10	30%
E	$10	10	33%

At $10/share, Security E has the highest price and therefore the highest weighting in the index. Security B, on the other hand, costs only $1/share; its weighting barely makes a blip in the overall basket.

A price-weighted index has many advantages: its weighting scheme is simple to understand and its daily value easy to calculate (it’s simply the sum of all the security prices divided by the total number of constituents).

The problem is, a security’s price alone doesn’t necessarily communicate its true market value. It ignores market forces of supply and demand. To fix this, we need a different weighting scheme.

The market-capitalization weighted index

Market-capitalization weighted indexes (or market cap- or cap-weighted indexes) weight their securities by market value as measured by capitalization: that is, current security price * outstanding shares. The vast majority of equity indexes today are cap-weighted, including the S&P 500 and the FTSE 100.

In a cap-weighted index, changes in the market value of larger securities move the index’s overall trajectory more than those of smaller ones. Let’s look at the same hypothetical five-member index, this time cap-weighted:

SECURITY	CURRENT PRICE	OUTSTANDING PRICE	MARKETING CAP	WEIGHTING
A	$3	50	150	15%
B	$1	50	50	5%
C	$7	70	490	51%
D	$9	20	180	19%
E	$10	10	100	10%
TOTAL MARKET CAP			970	100%

At $7/share, Security C doesn’t have the highest price, but it does have the largest market capitalization and thus the highest weighting in our index. Meanwhile, Security E, the highest priced security but also the one with the smallest number of outstanding shares, has fallen from the largest piece of the pie to second smallest.

The advantage of a cap-weighted index is obvious: It reflects the way markets actually behave. Larger companies do in fact have more dramatic effects on the overall market than smaller companies. It’s also a self-rebalancing methodology, in that as a company’s price or outstanding share quantity changes, so too does the proportions of stocks in the index basket.

But cap-weighted schemes aren’t perfect. For example, sometimes companies have shares that aren’t fully available for trade on the open market (such as government-held shares, or large privately-controlled holdings). In this case, pure cap weighted schemes would misrepresent the actual investible market cap available.

Most index providers adjust their cap-weighted indexes accordingly using a free float factor, or the percentage of shares available for trading.

Free Float Shares = (Shares x Free Float Factor)

So the free float market cap would be:

Float Market Cap = (Price x Shares x Free Float Factor)

There’s a more systemic downside to cap weighting, in that such indexes inherently assume that the EMH always holds—which isn’t necessarily true. Recent research shows that cap-weighted indexes tend to give too much weight to securities the market has overvalued and too little weight to ones it has undervalued. As a result, true market value is skewed.

Alternative weighting schemes to cap-weighting have gained more favor in recent years. These are covered briefly in the next section.