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 One day this past summer, an email arrived from the publisher of this periodical asserting that the old was again new. More specifically, he postulated that the Dow Jones industrial average, which is price-weighted, is really the first manifestation of the "alternative" weighting methodologies in indexes. The thing these methodologies are alternative to, of course, is market-capitalization weighting.
There is no mystery about how this idea germinated. In the past few years, there has been an eruption of new stock indexes that weighted their components by a series of different measures such as sales, earnings, dividend payouts and dividend yields. Weightings also have been hammered out of combinations of these and other "fundamental" statistics, such as price/earnings and price/book-value ratios. In a number of indexes, these factors also were used in some degree to select the components as well as weight them. Still others equally weight their stocks. Alternative weighting basked briefly in the faddish limelight before the market collapse this past fall cleaned everybody's clock.
The vast majority of indexes are weighted by market capitalization (price multiplied by outstanding shares). This methodology design was introduced in the 1920s by Standard Statistics Co., an ancestor of Standard & Poor's, and popularized in academic and professional channels in the 1930s by the Cowles Commission for Research in Economics. After World War II, the S&P 500 was used in academic work leading to the formulation of modern portfolio theory and the capital asset pricing model. These theories, based on the premise that the stock market is "efficient," underlie the investment world to this day.
Most "market-cap" indexes nowadays are the "float-adjusted" variation in which just the shares readily available for public investors are used to calculate capitalization. A few also place ceilings on individual stock weights to make the indexes—and, more importantly, any investment products based on them—comply with regulatory diversification rules.
Price-weighting certainly is not in that mainstream, so in this respect it is an alternative to market-cap. Historically, of course, it was the other way around. Charles Dow inaugurated price-weighting with his first index in 1884, and continued with that method when he created the industrial average in 1896. Not that he had much of a choice, as he worked without a staff of clerks or a computer.
So, market-cap weighting appeared as an alternative to price-weighting roughly 40 years after Dow began his work. The Dow Jones Averages, with their price-weighting methodology, retained their primacy during the first half of the 20th century largely because of another factor: timeliness. The Dow Jones industrial average could be computed in a minute with pencil and paper, while Standard Statistics had all it could do to push its data-heavy indexes out the door once a week. Only in the 1950s, when computing power reached an adequate level and became widely available, could Standard & Poor's generate a 500-stock index on a daily basis. It took even longer to achieve intraday, "real-time" calculations.
But that was then and this is now. Casting aside the inconvenient truth of chronology, the question becomes, is price-weighting a viable alternative to market-cap weighting? The short answer is yes.
A Viable Alternative
Exhibit A is the DJIA (and the other DJ Averages). The Dow's correlation to the S&P 500 over the past 25 years is 0.95, with 1 representing perfect, lockstep movements. Being 470 stocks smaller, the Dow is a bit more volatile than the S&P 500 (the standard deviation returns over those same 25 years are 14.96 percent versus 14.70 percent, respectively), but they are both telling the same story about the same stock market regardless of their weighting differences.
Exhibit B is the PHLX Semiconductor Sector Index, better known as SOX. It is a price-weighted tracker of 18 semiconductor stocks. Since 2001, its correlation to the Dow Jones U.S. Semiconductors Index, a market-cap-weighted indicator with 145 stocks, is 0.9686.
The long answer about the viability of price-weighting is, well, longer. The best place to start is with price, which arguably is the most important "fundamental" of all. There is no market without price. There are no transactions of any kind-—not just stocks—without price. It is what all investors watch. It is what all securities indexes track, no matter how their components are selected and weighted. Price movements propel market-cap indexes far more than changes in float-adjusted shares, because prices are real-time contributors, while outstanding shares and float factors in many cases are updated only quarterly.
The problem is that price alone does not distinguish the relative size of companies. A large company's stock can have a low price (General Motors, anyone?). And a small company's shares could be high-priced (at its price peak, Enron was the fourth-largest stock in America, while its actual assets indicated it really was worth a fraction of its market capitalization). The portfolio theorists not unreasonably object to weighting a small company more heavily than a large one, but only because they believe the index should reflect the "efficient" market's structure. If you had enough money to buy up all the stocks, your portfolio would be market-cap-weighted; market-tracking purists want their indexes to be weighted that way, too.
If the purpose of an index is not to reflect the broad market or a significant part of it, however, the importance of using market-cap weighting diminishes considerably—even to the point of irrelevance. That is the situation for many of the "alternatively weighted" indexes that have sprouted recently and are based on the belief that the market has inefficiencies, which can be exploited.
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