Managers of exchange-traded funds and mutual funds often buy stocks that are in an index to mimic the index's performance. Indexes and fund portfolios can be weighted by capitalization or by giving equal weighting to all stocks. "Cap-weighted" means buying more of the stocks of companies that have higher value for their outstanding shares. Equal weighting means buying the same amount of each company that is in an index. These approaches provide different investment results.
Cap-weighted Indexes, ETFs and Mutual Funds
A cap-weighted portfolio looks at the value of each company's shares. For example, if company XYZ has 25,000 shares outstanding and the share price is $100, the market cap for company XYZ is $2.5 million. Now let's say that the total market cap for all companies in the portfolio is $250 million. That means company XYZ accounts for 10 percent of the total value of the portfolio. The index or the fund following that index would make sure that 10 percent of its money is invested in company XYZ.
Equal-weighted Indexes, ETFs and Mutual Funds
Equal weighting involves putting the same dollar amount into each stock in a portfolio. If the portfolio contains 100 stocks, for example, and the total amount invested is $1 million, that means each stock would represent $10,000 of stock purchases. As stock prices rise and fall, the manager must buy and sell stocks to make sure that the amount invested in each stock remains equal to the amount invested in other stocks in the portfolio.
Pros and Cons of Equal-Weighted Portfolios
Conventional Wall Street wisdom is that smaller companies have the potential for greater growth than larger companies. Small companies can capture market share and investor interest more quickly, whereas large companies tend to grow at a steadier pace because they are not as likely to suddenly catch the attention of investors. An equal-weighted investment means a portfolio has a higher representation of smaller, cheaper companies. If those small companies have dramatic gains, the investor can make more money on those stocks than on the larger stocks. The downside, however, is that smaller companies have a higher risk of failure.
Pros and Cons of Cap-weighted Portfolios
A cap-weighted portfolio can be safer than an equal-weighted portfolio. Because more money goes into the more stable large companies, the investor reduces risk. That lower risk comes with a price, however. If one of the smaller companies grows quickly, the investor has less money in the stock and that means she won't make as much as she would have if she had invested a higher percentage of money in the small-cap company.
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