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Weighted Average Market Capitalization Definition
Weighted average market capitalization is a form that involves the formulation of stock market index on the basis of market capitalization of the stocks of index. Big organizations would hence receive a bigger chunk of an index as compared to small cap stocks. This states that the rise and fall of an index would be dependent on a small stock set.
One of the most popular market capitalization weight index is that of the S&P 500 that records 500 biggest assets through market capitalization. Of the total index, the best four holdings including Apple (AAPL), Microsoft (MSFT), Facebook (FB), and Amazon (AMZN) comprise of 10% share. The S&P 500 measures the financial performance of the wider market and sets a standard for performance.
A Little More on What is Weighted Average Market Capitalization
The weighted average market capitalization is calculated by multiplying the existing market price with the number of shares outstanding, and then considering an average for the purpose of knowing weight. For instance, the total market capitalization of stocks in an index is $100 million. The market capitalization of a company, being $1 million, constitutes 1% of the total index. Morningstar ascertains the benchmark by considering the geometric mean of the market capitalization of the fund’s’ stocks. However, there are many other users who prefer using an arithmetic mean.
According to many investors, a weighted average market capitalization is a preferred tool for allocating assets because it exhibits how market actually behave or react. This enables the bigger firm to have a bigger control over the index, just like in the S&P 500. This ultimately creates a natural rebalancing process that allows the developing firms to enter the index, and negates the ones with poor performance. Investors are of the belief that the methodology leads to lesser risks as a bigger chunk of the fund gets allotted to consistently performing firms.
Alternatives to Weighted Average Market Capitalization
However, this strategy faces a few drawbacks. Just as in history, there are times when small cap stocks perform better than the bigger ones, and when this happens, there are lesser chances for index investors for receiving big returns. Also, market cap-weighted indices such as the S&P 500 offer an illusion of diversification, however, there are just a few stocks that influence this movement.
Alternatives to weighted average market capitalization
There are many other alternative mechanisms that asset allocation offers. Some of them are price weighting, equal market cap weighting, and a lot more. The average mean of many stock prices leads to the calculation of the holdings of a price-weighted index. The Dow Jones Industrial Average is one of the most famous indices uses price weighting.
References for “Weighted Average Market Capitalization”
Academic research for “Weighted Average Market Capitalization”
Mutual fund performance and market capitalization, Madden, G. P., Nunn Jr, K. P., & Wiemann, A. (1986). Mutual fund performance and market capitalization. Financial Analysts Journal, 42(4), 67-70.
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[PDF] A study of low-volatility portfolio construction methods, Chow, T. M., Hsu, J. C., Kuo, L. L., & Li, F. (2014). A study of low-volatility portfolio construction methods. Journal of Portfolio Management, 40(4), 89-105.
[PDF] A framework for assessing factors and implementing smart beta strategies, Hsu, J., Kalesnik, V., & Viswanathan, V. (2015). A framework for assessing factors and implementing smart beta strategies. The Journal of Index Investing, 6(1), 89
Performance of enhanced index and quantitative equity funds, Ahmed, P., & Nanda, S. (2005). Performance of enhanced index and quantitative equity funds. Financial Review, 40(4), 459-479
Commonalities in investment strategy and the determinants of performance in mutual fund mergers, Namvar, E., & Phillips, B. (2013). Commonalities in investment strategy and the determinants of performance in mutual fund mergers. Journal of Banking & Finance, 37(2), 625-635.