In some respects, weighting can create a more accurate
measurement of general market movements, since the price changes
of a large, well known, usually less volatile company may be a
truer measure of what’s happening in the marketplace than
the ups and downs of a smaller, younger, or less established company.
However, weighting can, and often does, skew the
results when a handful of large-cap or highly priced stocks behaves
differently than lower-weighted stocks. For example, the price-weighted
DJIA
may rise based on the performance of its most expensive stocks,
even if the majority of the stocks are falling in price, or vice
versa. And the capitalization-weighted S&P 500 may suggest
the market is booming — or faltering — based on the
performance of fewer than 10% of the stocks it tracks.
When indexes are used to evaluate the performance
of mutual funds, as they typically are, the impact of weighting
may be felt even more directly, since a fund manager is probably
more likely to try to diversify the fund portfolio than to buy
only the largest or most expensive stocks. If the fund results
don’t replicate what seems like the appropriate benchmark,
especially when that
benchmark
is on the upswing, the manager’s skills may be underappreciated.
Heavy handed performance
At the height of the last bull market on March 31,
2000, the top 100 stocks in the
S&P
500
had 76% of the weight in the index.
By contrast, the same 100 stocks had only 20% of the
weight in the S&P Equal Weight Index (S&P
EWI), which tracks the same 500 stocks.
