How Indexes are created:
Ramifications for the Index Investor            Page 3

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

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