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Weighing up indexes: From cap-weighted to alternative

An index’s construction technique determines its long-term behavior, so it’s worth paying particular attention to questions of weighting.

Most standard equity indexes are capitalization weighted. In other words, the weightings of stocks within the index reflect each constituent company’s market value (capitalization). The well-known FTSE 100, FTSE All Share, FTSE Developed and FTSE Emerging indexes all follow this approach.

It’s obvious why such indexes are used as the principal type of benchmark in portfolio performance measurement and index-tracking financial products. Capitalization weighted indexes represent the opportunity set of stocks (or bonds) in the markets they span.

By comparison with other types of index, they offer high levels of liquidity and capacity and, as they are self-rebalancing (index components are only added or deleted after crossing a pre-identified capitalization threshold), capitalization weighted indexes experience lower levels of turnover.

But this approach, though standard, is far from the only one. Alternative approaches to weighting indexes have a long history.

For example, the first index-tracking pension fund portfolio, set up on behalf of the Samsonite Luggage Company in 1971, aimed to hold an equal cash amount of all the 1,500 or so securities on the New York Stock Exchange (NYSE).

The managers of the Samsonite fund eventually abandoned their attempts at equal weighting, reportedly because of the performance drag caused by transaction costs (until 1975, trades on the NYSE carried fixed commissions of 0.25%, and an equal-weighted index incurs higher turnover than a capitalization-weighted index). Most institutional index funds launched in the 1980s and 1990s used capitalization weighted benchmarks.

But in the last decade there’s been great interest in alternatives to capitalization weighting, partly because of the experience of the 1999/2000 equity market bubble, which saw many headline indexes develop a significant concentration in technology, media and telecom stocks.

Many market observers describe non-capitalization weighted indexes by a single term, “smart beta”. This is unhelpful, for two reasons: first, capitalization-weighted benchmarks aren’t stupid; second, alternatively-weighted indexes are far from homogeneous.

Adding to the potential confusion, factor indexes, which aim to reflect the performance of specific stock-level characteristics, are often lumped together with smart beta, even though factor indexes may be weighted by constituents’ capitalization.

FTSE believes it’s helpful to distinguish between these two types of index.

Alternatively weighted indexes are those which depart from capitalization weighting and seek to achieve a specific, index-level objective, such as enhanced diversification or reduced volatility.

Factor indexes are indexes designed to offer exposure to a particular factor or attribute, such as value or momentum.

We will explore factors and factor indexes in greater detail in forthcoming articles on this site.

 

 

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