This page explains how a value weighted stock index is constructed, the biases and practical problems this calculation method can cause, as well as possible adjustments to address these problems.
Stock index calculation methods
Value weighting (also known as market cap weighting or capitalization weighting) is one of the three commonly used methods for stock index calculation (the other two methods are price weighting and equal weighting).
Value weighted stock indices are currently the most popular of the three stock index weighting types, used by many of the most widely watched indices worldwide. For example, the S&P500 is a value weighted index.
Value weighted index calculation
The weights of individual stocks in a value weighted equity index are proportional to their market capitalization. For example, shares in a company with market cap of 50 billion dollars will have two times greater weight in the stock index than shares in a company whose market capitalization is 25 billion.
Capitalization weighted indices are adjusted for corporate actions – for example, when a company issues new shares and its market capitalization increases, its weight in the stock index is increased too. Most value weighted indices are reviewed and reconstituted regularly.
Value weighted index disadvantages and biases
The advantage of value weighted stock indices is that companies and industries are represented according to their market capitalization, which is a good (though not perfect) indicator of importance in the economy and in the stock market. The downside is that this method sometimes favors the biggest companies too much. Companies in some industries (like energy or financial services) typically have big market capitalization and may therefore dominate the index. As a result, replicating a value weighted stock index can lead to insufficient diversification.
Single position size limits
In some smaller markets (like Austria, Hungary, or the Czech Republic), two or three biggest companies (typically banks, oil companies, telecoms, or utilities) can represent more than half of the index. This can be a problem for institutional investors who are restricted by position size limits introduced by various laws and regulations.
For example, when a fund's limit on a single stock position is 10% and a particular banking stock represents 15% of the index, the fund manager can't replicate the index and is forced to have a relative bearish exposure on this particular stock, even when he is bullish and likes the company's fundamentals.
For example, the biggest constituent of the Austrian ATX stock index is Erste Bank with 19% share (as in November 2021). A fund manager who has the ATX index as benchmark and a single position limit of 10% must be underweighted Erste Bank relative to the index, regardless of his own outlook on the stock. If Erste Bank performs better than the overall market, this fund's relative performance will suffer.
One stock limit adjustment to value weighted indices
In order to prevent one or two large cap stocks from dominating the index, the calculation methodology for some value weighted indices includes the maximum limit for single stock's share in the index (e.g. it is 10% for the German DAX).
Free float adjusted value weighted indices
Very often, market capitalization weighted indices are also adjusted for free float (the portion of company's shares actually available for trading).
For example, a company may have large market capitalization, but 98% of its shares are closely held by a big investor (e.g. a parent company) and therefore only 2% of the company's shares (= free float) are available to investors on the stock market.
Compare this to another company, whose market capitalization is half the first company's market cap, but all its shares are held by portfolio investors and regularly traded on the stock market (free float is 100%). Which one of the two stocks is more representative of the stock market situation and sentiment?
Examples of value weighted stock indices
The value weighted index construction method is the most popular in these days and you will find many examples of value weighted indices among the best known equity benchmarks:
- S&P500 and other Standard & Poor's equity indices
- The popular small-cap benchmark Russell 2000 and other Russell equity indices
- MSCI (Morgan Stanley Capital International) indices
- European stock indices, e.g. German DAX, French CAC, and FTSE in the UK
- Japanese TOPIX (Tokyo Stock Exchange Price Index)
Examples of indices which are NOT value weighted include the Dow Jones Industrial Average and Nikkei 225.