Types of Stock Indices (Part 3)

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Beside Market-Capitalization Weighting , Free-float adjusted Market-Capitalization Weighting and Price Weighting, there are 5 different types of indices by weighting method.

  • Equal Weighting

It based indices give each constituent stocks weights of 1/n, where n represents the number of stocks in the index.

This method produces the least-concentrated portfolios. Equal weighting of stocks in an index is considered a naive strategy because it does not show preference towards any single stock. Z

eng and Luo (2013) notes that broad market equally weighted indices are factor-indifferent and randomizes factor mispricing.

Equal weight stock indices tends to overweight small-cap stocks and to underweight large-cap stocks compared to a market-cap weighted index.

These biases tend to give equal weight stock indices higher volatility and lower liquidity than market-cap weight indices.

For example, the Barron's 400 Index assigns an equal value of 0.25% to each of the 400 stocks included in the index, which together add up to the 100% whole.

  • Fundamental Factor Weighting

It based indices, or Fundamentally based indexes, weight constituent stocks based on stock fundamental factors rather stock financial market data.

Fundamental factors could include sales, income, dividends, and other factors analyzed in fundamental analysis.

Similar to fundamental analysis, fundamental weighting assumes that stock market prices will converge to an intrinsic price implied by fundamental attributes.

Certain fundamental factors are also used in generic factor weighting indices.

  • Factor Weighting

It based indices weight constituent stocks based on market risk factors of stocks as measured in the context of factor models, such as the Fama–French three-factor model.

These indices Common factors include Growth, Value, Size, Yield, Momentum, Quality, and Volatility.

Passive factor investing strategies are sometimes known as "smart beta" strategies.

Investors could use factor investment strategies or portfolios to complement a market-cap weighted indexed portfolio by tilting or changing their portfolio exposure to certain factors.

  • Volatility Weighting

It based indices weight constituent stocks by the inverse of their relative price volatility.

Price volatility is defined differently by each index provider, but two common methods include the standard deviation of the past 252 trading days (approximately one calendar year), and the weekly standard deviation of price returns for the past 156 weeks (approximately three calendar years).

  • Minimum Variance Weighting

It based indices weight constituent stocks using a mean-variance optimization process.

In a volatility weighted indices, highly volatile stocks are given less weight in the index, while in a minimum variance weighting index, highly volatile stocks that are negatively correlated with the rest of the index can be given relatively larger weights than they would be given in the volatility weighted index.

Reprinted from eTorothe copyright all reserved by the original author.

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