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Do Indices have a Weight Problem?

We examine the pros and cons of equal-weight indices versus their traditional market-capitalisation-weighted brethren

Stock indices are constructed using a variety of criteria to select their constituents such as market capitalisation, sector, and geography. However, the vast majority of equity indices (and hence most equity ETFs) weight their component stocks solely by market-capitalisation. The rationale for this practice is that the method best represents the investable opportunity set facing investors. Intuitively, since the goal of an index is to track the performance of an underlying market, it makes sense that a large company like Royal Dutch Shell (RDSB), with operations all over the world, is weighted more heavily than a small oil and gas producer with only one significant field to its name.

 

There are also academic reasons for the popularity of the market-capitalisation weighting. The well-known Capital Asset Pricing Model (CAPM) argues that because each additional asset added to a portfolio increases diversification (until there are no more assets to add), a portfolio which proportionally includes the whole 'market' offers the best possible ratio of risk to return. A more practical reason behind the popularity of market cap weighting is the relative ease of replicating a market capitalisation-weighted index; it's cheaper to trade the more liquid shares of larger companies which by definition will comprise a large proportion of a market-cap weighted index, than it is to trade more shares of the smaller companies that will comprise relatively more of an equal-weight index. So because ETFs and open-end index funds can inexpensively track the performance of a market-capitalisation weight index, funds tracking indices employing more exotic weighting methods face a higher hurdle from the onset in the form of relatively higher expenses.

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About Author

Morningstar ETF Analysts  research hundreds of ETFs available to European investors. The Morningstar Rating for ETFs is based on a risk-adjusted performance measure

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