Is It Time To Use Trading Value For Index Weighting?
As indexed assets continue to grow, investors are beginning to pay closer attention to all aspects of indexes, including their weighting methodologies. We are proposing a new index weighting system that utilizes "trading value" as the driving factor in weighting components within an index. Liquidity has been the key driving force behind changes in index weighting methodologies in the past, and our new system offers the most accurate measure of liquidity for index constituents. Our preliminary study also indicates that using "trading value" to weight index components offers the additional benefit of potentially robust performance.
The Rationale Behind Weighting Systems
Index experts have always strived to improve and finetune the construction and weighting methodologies for their indexes, and to adapt them to changing times.
Over a century ago, in 1896, when Charles Dow introduced the Dow Jones Industrials Index to the world, he used price as the weighting factor for the new index: The stock prices of the eleven companies in the index were added up and then divided by eleven. This was a fine first effort - even a revolutionary breakthrough - but still, it might not have been the ideal weighting methodology.
Over the years, market-capitalization weighted indexes, like those managed by Standard & Poor's or Russell came to be viewed as the gold standard for index construction. Weighting components by market capitalization address concerns about accurate market representation and limited turnover. This methodology, aided by the popularity of William Sharpe's Capital Asset Pricing Model , became the dominant methodology in the industry.
After decades of using market-cap weighting, however, indexers realized that liquidity still represented a certain level of challenge. In the mid-1980s, the Toronto Stock Exchange in Canada and Solomon, Smith Barney (later Citigroup, then S&P) introduced the concept of free-float-adjusted weightings. The idea was to account for shares that are rarely available for trading, such as those controlled by the founding family of a company. The float-adjusted weighting methodology removes these strategically held shares from market capitalization calculations; stocks are weighted based only on their "liquid" share counts.
MSCI was the first major index publisher to adopt float adjusted weightings for its indexes, and there has been continuous trend towards using them across the industry. Recently, both Dow Jones and S&P adopted the float-adjusted index weighting methodology.
Is There A Better Way Of Weighting An Index?
Market capitalization represents the size of a company and its economic importance, and free-float-adjustments address investors' concerns over liquidity. Both are very important issues for investors, and the popularity of these methods speak for their merits.
For investors, however, the size of a company does not equal its importance as an investment opportunity, so straight market cap weighting does not fully reflect the importance of a stock to an investor. And while float-adjusted weightings help address liquidity concerns, there is more to be done.
For instance, investors have long noticed that a certain portion of the shares of many companies is often held by long-term and/or strategic investors (e.g., Warren Buffett of Berkshire Hathaway). These shares generally are not available for trading, but they are also difficult to account for: Who decides if a particular shareholder is "strategic" and "longterm"? As a result, the process of adjusting float to account for these strategically held shares can be subjective.
We believe there is a better methodology to solve the liquidity problem, and are introducing the idea of using of "trading value" as a weighting determinant in index construction.
Trading Value Definition
"Trading value" is defined as: Price x Number of Shares Traded.
In the formula above, TV is trading value, P is share price, S is number of shares traded (volume), n is number of trades in a day. The formula essentially represents the weighting of each component in the index (its share price multiplied by its trading volume for dollars traded in each stock daily) as a part of the total dollar amount of shares traded in the index, calculated within a given time factor.
Simply put, trading value measures all of the actual transactions taking place in the market, therefore giving the most accurate representation of the market and, consequently, its liquidity.
When we look at the evolution of index weighting methodologies, moving from price to market cap to freefloat- adjustments, it is clear that liquidity has been the primary concern for investors. The idea of using trading value to weight components in an index is the ultimate answer to investors' pursuit of the critical liquidity factor.
The New Era Of Index Weighting
Index weighting is clearly an important factor in constructing indexes. The right weighting system makes indexes more realistic as benchmarks, and more easily "investable" for even the largest investor. Investors and index publishers alike have not paid much attention to index weighting in the past. Fortunately, things have changed, and index weighting is now a topic of discussion among investors and index publishers, which we believe will lead to better methodologies.
Our preliminary study indicates that the market-cap weighting difference between the largest stock and smallest stock can be as big as 1,000 times in the S&P 500 Index, which means that the smallest stocks have an insignificant impact on the index. By using trading value to weight components, the differences in weight between top and bottom stocks in an index could be reduced substantially, with some of the more liquid, actively-trading small-cap stocks gaining more representation in the index.
Theoretically, we also expect to see better performance for trading-value weighted indexes vs. traditional floatadjusted indexes, as smaller companies generally outperform larger ones over time; when smaller stocks are assigned a larger weight in an index, their performance will contribute more to the bottom line. This could be another potential benefit of using trading values in index weighting.
While market capitalization represents the economic importance of a company, and while free-float-adjustment tries to account for liquidity, trading value measures exactly what is happening in the marketplace. We are confident that, from the investment perspective, trading value would be the ideal weighting methodology in constructing indexes.