Value weighted index
Also written Market-value weighted index · Market capitalisation weighted index · Market capitalization weighted index
An index weighting each stock by its market capitalisation, or free-float market capitalisation, divided by the total — the most popular method, and the natural basis for index funds and derivatives.
In plain language
In a value-weighted index, bigger companies count for more. Each stock's weight is its market capitalisation — shares outstanding times price — as a share of the total market capitalisation of all constituents.
The workbook calls it the most popular of the four ways of assigning weights.
The logic is that the index should behave like the market itself. If a company is half the value of the segment, a 10% move in its price should move the segment about 5%, and in a value-weighted index it does. A 10% move in a tiny company barely registers.
Most modern indices use free-float market capitalisation rather than full market capitalisation. Free float excludes shares that are not really available to trade — promoter and controlling holdings, government promoter stakes, strategic stakes, cross-holdings, locked-in shares and similar.
How it works
Weights (Example 8.2). Five securities have a total market capitalisation of Rs 970. Security C, worth Rs 490, has a weight of 490 ÷ 970 = 50.52%. Security A, worth Rs 150, has 15.46%.
Level. For a base of 100, the divisor is 970 ÷ 100 = 9.7. Three months later total market cap is 835, so the index is 835 ÷ 9.7 = 86.08.
Properties the workbook highlights (section 8.3.2):
- A given percentage change in a large company has a greater impact than the same change in a small one.
- There is an automatic adjustment for stock splits and other capital changes, since price and share count move together.
- That makes it the ideal choice for index funds and index derivatives: a security's weight adjusts automatically as its market value changes, so a fund holding shares in index proportion needs no rebalancing for price moves.
The criticism (section 8.3.4). Weighting by market value means the index overweights overvalued stocks and underweights undervalued ones — a stock that becomes expensive automatically becomes a bigger part of the index. That is what fundamental-weighted indices were created to counter.
Free-float adoption. BSE Sensex moved from full market capitalisation to free float with effect from September 1, 2003; NIFTY 50 moved on June 26, 2009.
The formula
Market value of stock i = Shares outstanding (or free-float shares) × Price
Weight of stock i = Market value of i ÷ Σ market values
Index = Σ market values ÷ Divisor
A worked example
The same price moves, three weighting schemes. Using the workbook's Examples 8.2 and 8.3, five stocks move like this between T0 and T1:
| Stock | Price T0 | Price T1 | Shares | Mkt cap T0 | Mkt cap T1 |
|---|---|---|---|---|---|
| A | Rs 3 | Rs 0.50 | 50 | 150 | 25 |
| B | Rs 1 | Rs 1 | 50 | 50 | 50 |
| C | Rs 7 | Rs 7 | 70 | 490 | 490 |
| D | Rs 9 | Rs 9 | 20 | 180 | 180 |
| E | Rs 10 | Rs 9 | 10 | 100 | 90 |
| Total | 30 | 26.50 | 970 | 835 |
Value-weighted: 835 ÷ 970 − 1 = −13.92%
Price-weighted: 26.50 ÷ 30 − 1 = −11.67%
Equal-weighted: (−83.33 + 0 + 0 + 0 − 10) ÷ 5 = −18.67%
Stock A collapsed 83%. In the equal-weighted index it is one-fifth of the result, so the index falls hardest. In the value-weighted index A was only 15.46% of the value, so the fall is moderated. In the price-weighted index, A's low price gave it little influence at all.
An index fund with Rs 97 crore tracking the value-weighted index would have been worth Rs 83.5 crore at T1 — and would have needed no trades to stay in line, because every holding's weight moved with its own market value.
Why NISM asks about it
Chapter 8, section 8.3 lists the four weighting schemes and calls value weighting the most popular; section 8.3.2 and Box 8.2 give Examples 8.2 to 8.4 and the free-float exclusions; section 8.3.4 gives the overvaluation criticism. Expect a weight calculation, the "ideal for index funds and derivatives" rationale, and the free-float switch dates.
Common exam traps
- Value-weighted indices adjust automatically for stock splits. Price-weighted indices do not.
- In a value-weighted index, large companies have more influence; in a price-weighted one, high-priced shares do. They are different things.
- The criticism is overweighting overvalued stocks, not overweighting small ones.
- Free float excludes controlling, promoter, government-promoter, FDI-route, strategic, cross-holding, employee-welfare-trust and locked-in shares.
- Sensex moved to free float from September 1, 2003; NIFTY 50 from June 26, 2009. Easy to swap.
- Most popular method = value weighted, per the workbook — not equal weighted.
Check yourself
1.A value-weighted index stands at 86.08. On reconstitution, one stock is replaced and the total market capitalisation of the new constituents becomes ₹1,230. To keep the index unchanged, the new divisor should be about:
- a)12.30
- b)9.70
- c)14.28
- d)8.35
Show the answer
Answer: (c) 14.28
The divisor is chosen "in such a way that the value of the index remains the same after the restructuring". New divisor = new total market cap ÷ current index level = 1,230 ÷ 86.08 = 14.28 (Example 8.4).
Why the others are wrong: 12.30 divides by the base value of 100, which would reset the index to 100. 9.70 is the original divisor, which would push the index to about 126.8. 8.35 is 835 ÷ 100, from an earlier table.
Where this is taught
- Series XXI-B · Chapter 12: Introduction to Indicesintroduced here
- Series XIX-C · Chapter 10: Introduction to Indices and Benchmarkingintroduced here
- Series XIX-E · Chapter 8: Indices and Benchmarkingintroduced here
Related terms
- Equal weighted indexAn index where every constituent starts with the same weight; as prices move the weights drift apart, so the portfolio must be rebalanced by selling winners and buying losers.
- Free floatThe part of a company's shares readily available for trading — broadly, what is not locked up with promoters. Indices, position limits and MWPL are all measured on it.
- IndexA statistical indicator that tracks a portfolio of securities representing a market or part of it, expressed as a change from a base value — so the percentage move matters, not the number itself.
- Price-weighted indexAn index in which each stock counts in proportion to its share price — the sum of prices divided by the number of stocks — so a high-priced share moves it most, whatever the company's size.
- Fundamental weighted indexAn index weighting constituents by company fundamentals such as sales, profits, book value, cash flow or dividends rather than market value — built to avoid overweighting overvalued stocks.
- Index divisorThe number an index total is divided by — set at inception so the index starts at a convenient 100 or 1,000, then adjusted so splits and constituent changes do not move the index level.
- Style indexAn index of value stocks (low P/E, low P/B, high dividend yield) or growth stocks (the reverse), built to benchmark style managers — with far higher turnover than broad market indices.
- GDP weighted indexA global index that weights each country by the size of its economy (GDP) rather than its stock market, correcting the tilt of market-cap indices towards developed countries.
- NIFTY Hybrid Index seriesA family of 6 NSE indices blending NIFTY 50 total return with an aggregate fixed income index in fixed proportions, reset monthly, to benchmark portfolios that hold both equity and debt.
- Dollar denominated indexAn index built to measure returns on Indian equity in US dollar terms — NIFTY50 USD restates the NIFTY 50 by the ratio of the base-date exchange rate to the current one.
- Smart Beta FundAn extension of index funds and ETFs that changes how the index is weighted — equal weights or other parameters instead of market capitalisation — to improve returns, diversify more and reduce risk.
- Base valueThe starting level an index is set to on its base date — often 100 — from which every later index value is expressed as a change, so the percentage move matters more than the number.
- Market capitalizationThe market value of a company: total shares outstanding multiplied by the current market price. It sets index weights and underpins derivatives eligibility and position limits.
- Index CommitteeThe specialised committee that generally takes the final decision on including or removing a security from a stock index, once the stock has met the index construction managers' eligibility criteria.
- Index revisionA continuous exercise changing an index's composition — replacing existing constituents with new ones because the trading paradigm has shifted — distinct from maintenance, which reacts to a single corporate action.