Indices are useful to gain insights into the internal dynamics of markets. If 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.
Many professional and personal investors research stocks using a favorite metric, whether it is earnings growth, price/earnings ratio, price/book value or a combination of several. After researching and culling their selections to a manageable number they enter buy orders for a roughly equal amount 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 research the investor decides that Apple and Staples will both benefit from a growing economy and 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, many 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 indices, meaning that larger companies are given more weight, more clout so to speak, than small companies (Market capitalization is the aggregate valuation of the company based on its current share price and the total number of outstanding stocks).
If our investor bought Apple and Staples in the way an index fund bought the same stocks the investor would buy $9,865 of Apple and only $139 of Staples, reflecting the fact that Apple’s market capitalization is about 71 times as large as Staples’.
A capitalization-weighted index is useful because it captures the moves of large companies and thus gauges well the overall economic effect created by changing prices of these large firms. A 1% change in the price of Apple will have a wealth effect 71 times greater than a 1% move in the price of Staples so it is reasonable to give Apple a greater weight in order to capture the total amount of global wealth increased or diminished.
But individuals are not particularly concerned about an aggregate wealth effect, they want to know about their personal wealth effect. Capitalization-weighted indices tend to mask the results of individual investors because the indices 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 Staples’ stock. While not particularly useful in gauging an overall economic effect it can be a much better indicator of the results of a typical investor.
Over a long period of time the returns of the capitalization-weighted and equal-weighted indices 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. In 2014, for example, the Wilshire 5000 Capitalization-Weighted Index gained 12% while the Wilshire 5000 Equal-Weighted Index gained only 4.3%. This large variance was due to the simple fact that smaller companies underperformed large companies during the year.
Source: Wilshire Associates @ Wilshire.com/indexcalculator
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.
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