How Indexes are created:
Ramifications for the Index Investor

By Rahul Seksaria
Date

Not all indexes are created in the same way. How they are put together can affect investor returns. Three methods primarily used to construct indexes are:

  • Market value-weighted Method - Each stock is given a weighting proportional to its market capitalization
  • Price Weighted Method - Each stock is given a weighting proportional to its market price
  • Equal Weighted Method - Each stock is equally weighted in the index

The market value-weighted method, where a company worth $2 Billion is given twice the weight of a company worth $1 Billion, is the most popular way of creating an index. The Standard & Poor's 500 Index is one example. A market value-weighted index allows investors to best capture total economic activity and changes in valuation of the companies in the index. By giving larger companies higher weighting, this method reflects the fact that large companies have larger revenues and profits and that any change will have a larger effect on economic activity than change in smaller companies. The NYSE Composite Index, Nasdaq Composite Index, Wilshire 5000, London FTSE, and MSCI Indexes are all constructed using the market value methodology.

A price-weighted index overweights the performance of companies with higher listed stock prices. Richard Ciuba, Account Development Executive in the Indexing Group at Dow Jones explains why the DJIA (Dow Jones Industrial Average),

"The index was created a 100 years ago at a time when the main emphasis was on fixed-income instruments. It was simply computed as the average price of the 12 stocks that made up the index. The creators did not anticipate stock splits, run-offs, takeovers, mergers and acquisitions."

Early in this century, high prices were synonymous with larger companies and higher market caps. Things are different today but the old method is still used for computing the index. Why is the DJIA at 10,000 if it is supposed to be the average price of the 30 stocks in the index today? It is because it has been adjusted every time a stock split, a company paid a dividend of more than 10%, or a company in the group was replaced by another. The Japanese Nikkei 225 is also price-weighted.

An equally-weighted index makes no distinction between large and small companies, both of which are given equal weighting. The good performance of large-cap stocks is negated one-for-one by poor performance of smaller-cap stocks in this index. Since there are many more small companies than large ones, this strategy greatly overemphasizes the importance of small company activity.

The graph below demonstrate how an index of two stocks would be constructed with each index method, and how overweighting of high priced stocks occurs in price-weighting and how overweighting of small cap stocks occurs in the equally-weighted index.

The graph below demonstrate how an index of two stocks would be constructed with each index method, and how overweighting of high priced stocks occurs in price-weighting and how overweighting of small cap stocks occurs in the equally-weighted index.

Over time indexes can diverge from each other. The graph below shows the effect of a 20% decrease in Stock A's price and a 20% increase in Stock B's price on the indexes and the portfolio. The market value-weighted index (with high weighting on Stock A) falls by 12% and the price-weighted index (with high weighting on Stock B) rises by 6.67% while the equally-weighted index remains unchanged. The $1000 portfolio perfectly tracks the performance of the respective index. Keep in mind though that portfolio returns are higher than index returns that do not reflect the cash dividends paid by companies.

A change in prices also changes the weighting of stocks in both the market value-weighted and price-weighted index but does not affect the weighting of stocks in the equally-weighted index (always remains the same). Due to this, the portfolio tracking the equally-weighted index is now out of sink with the index and must be rebalanced, while the other two portfolios maintain correct weightings.

Computation of new index values: Market value-weighted: (80*.8) + (20*1.2) = 88, Price-weighted: (33.33*.8) + (66.67*1.2) = 106.67, Equally-weighted: (50*.8) + (50*1.2) = 100