How do company weights change an index?
An index can weight companies by market cap, price or equal weight. A large number of companies does not guarantee balanced diversification.
In a market-cap-weighted index, larger companies can have greater influence; sometimes only freely tradable shares are used and weight caps apply. In an equal-weight index, company weights are equal at rebalancing dates and then change with prices. An index is a measurement tool; to get exposure you can use a tracking product, whose results may deviate due to costs and tracking error.
In a fictional basket, Company A at 80% weight rises 10% and Company B at 20% weight falls 10%. Assuming initial fixed weights and no costs, the basket change is 0.8×10% − 0.2×10% = 6%.
Compute the same example with 50% weight for each company.
Investor.gov · Index funds ↗Check your understanding
What is the basket change in the 80% and 20% example?
- 0%
- 6%
- 10%
Answer and explanation
6%. Add the weighted changes for each company: 8% minus 2%.
What do you buy to get exposure to an index?
- The index itself, always
- A suitable product that tries to track it
- Its point value
Answer and explanation
A suitable product that tries to track it. An index is a measurement; the fund is an investment product with policy, costs and risks.
Continue learning
Price-to-Earnings (P/E): What is the price relative to earnings? — The price-to-earnings (P/E) ratio is the share price divided by earnings per share. It is a ratio, not a forecast and not a buy recommendation.
How does one fund unit represent a basket of stocks? — A unit in a fund gives a proportional share of a fund that holds assets; it is not one share in each company.
Two funds: Did we really diversify? — Different funds can hold the same companies. Check cumulative exposure, not just the number of funds.