Indexes are useful for gaining insights into the internal dynamics of markets. When using an index for comparison or benchmark purposes, it is critical to know what is actually being measured. Is performance an outgrowth of a unique stock selection process or a by-product of other, larger trends in the market? Understanding index construction lends insight into the question.
Some professional and personal investors research stocks using a favorite metric, whether it is earnings growth, price-earnings ratio, price-to-book ratio or a combination. After researching and culling their selections to a manageable number, they enter buy orders for roughly equal amounts of each selected security. Such parity reflects the investor’s conclusion that the growth prospects for the individual securities are equally attractive. For example, assume an investor has $10,000 to invest and wants to buy only two stocks. After doing some research, the investor decides that both Apple and Kellogg will benefit from strong brand recognition and a growing economy, and estimates the upside potential for each stock is 20%. In light of this, the investor buys $5,000 of each stock.
While this makes intuitive sense, it is not how a vast amount of money is invested in the United States. Instead, some investors simply choose a broad-based index fund, such as one tied to the S&P 500 Index or the Wilshire 5000. Both of these are capitalization-weighted indexes, meaning that large companies are given more weight (more clout, so to speak) than small companies. (Market capitalization is the aggregate valuation of a company, based on its current share price multiplied by the total number of shares outstanding.)
If our investor buys Apple and Kellogg stocks in the same way an index fund buys them, the investor would buy $9,750 of Apple and $250 of Kellogg to reflect the fact that Apple’s market capitalization is about 40 times the size of Kellogg’s.
A capitalization-weighted index is useful because it can gauge the overall economic effect created by a change in the price of each company’s stock. In this scenario, a 1% change in the price of Apple will have a wealth effect 40 times greater than a 1% change in the price of Kellogg, so it is reasonable to give Apple a greater weight in order to more accurately capture the increase or decrease of global wealth.
But individuals are not particularly concerned about the aggregate wealth effect; they want to know about their own personal wealth effect. Capitalization-weighted indexes tend to mask the results for individual investors because the indexes show a skewed, albeit useful, portfolio construction.
Many times it is more useful to look at the returns of an equal-weighted index. This type of index treats each company the same no matter what its size, so a 1% change in Apple’s stock price would have the same effect on the index as a 1% change in Kellogg’s stock price. While not particularly useful in gauging an overall economic effect, it can be a much better indicator of results for a typical investor.
Over a long period of time, the returns of the capitalization-weighted and equal-weighted indexes are similar as shown in the chart below. However, on an annual basis, returns can differ significantly, illustrating the differential performance of large and small companies. Over the past year (ending 3/31/2018), for example, the (capitalization-weighted) S&P 500 Index grew 13.99% while the S&P 500 Equal Weight Index grew 11.65%. This variance was due to the fact that smaller companies underperformed large companies during the year, as shown by the S&P SmallCap 600 Index.
Thus, understanding how an index is constructed will inform investors on return differences in portfolio construction style. Over the long term, it is not likely to matter much but can explain small capitalization biases (for or against) in any given year.