Learning Outcomes
After reading this article, you will be able to explain how security market indexes are constructed, differentiate among index weighting methods, and recognize key index biases that impact benchmark performance. You will identify the risks, advantages, and disadvantages of price, value, and equal weighting; spot reconstitution and survivorship biases; and evaluate how construction and weighting choices affect returns and risk for CFA Level 1.
CFA Level 1 Syllabus
For CFA Level 1, you are required to understand how different index construction, weighting, and maintenance methods impact index performance and bias. In this article, focus your revision on the following syllabus points:
- Explain the steps in index construction, including security selection, weighting, rebalancing, and reconstitution.
- Differentiate among price-weighted, market capitalization-weighted, float-adjusted, and equal-weighted index approaches.
- Identify and explain common index biases, such as survivorship bias and reconstitution effects.
- Recognize how biases and weighting affect the interpretation and use of security market indexes as benchmarks.
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
- Which index weighting approach gives the greatest influence to companies with the highest price per share, regardless of their relative size?
- Explain two main drawbacks of equal-weighted indexes in practice.
- What type of bias results when an index does not include companies that ceased trading during the measurement period?
- Why might regular index reconstitution lead to a drag on index performance?
Introduction
Market indexes are widely used benchmarks to measure returns of asset classes, regions, styles, or strategies. How an index is constructed—including which securities it contains, how holdings are weighted, and when rebalancing or constituent changes occur—directly affects its performance and interpretability as a benchmark. Understanding index construction, weighting, and biases is essential for CFA candidates to effectively assess performance attribution, compare managers, and interpret analytical results.
Index Construction: Selection and Maintenance
An index's value and its future performance depend on how its constituents are selected, the weighting method chosen, and the way it is maintained (through rebalancing and reconstitution).
Key Term: index rebalancing
The process of adjusting index constituent weights back to their target proportions, typically on a predetermined schedule, such as monthly, quarterly, or annually.Key Term: index reconstitution
The periodic process of adding or removing securities from the index based on rules for market capitalization, liquidity, or other criteria.
Security Selection
Indexes define an eligible universe using transparent, objective criteria (e.g., market capitalization, sector, or geography). Once the universe is set, rules (often based on size, trading volume, domicile, or other screens) determine which securities are included.
Index Weighting Methods
How securities are weighted in an index affects the return/risk characteristics. Common weighting approaches include:
- Price weighting: Stocks are weighted according to their market price per share.
- Market capitalization weighting: Weights are based on the total market value (shares outstanding × price).
- Float-adjusted market capitalization weighting: Only freely tradable shares are included, not those closely held.
- Equal weighting: Each constituent is given the same weight, regardless of size or price.
Key Term: price-weighted index
An index in which each security’s weight is proportional to its share price rather than market value.Key Term: market-cap-weighted index
An index in which constituent weights are proportional to each company’s market capitalization.Key Term: float-adjusted index
An index that weights securities based on market capitalization using only shares available for public trading.Key Term: equal-weighted index
An index in which all constituents are assigned the same weight, regardless of price or size.
Price-Weighted Indexes
Each constituent impacts the index in proportion to its share price. Prominent examples: Dow Jones Industrial Average, Nikkei 225.
Market-Cap-Weighted Indexes
The most common default for equity and bond indexes. Large-cap companies dominate the index, so their performance can overshadow the rest. Examples: S&P 500, FTSE 100.
Float-Adjusted Market-Cap Indexes
Institutional investors commonly use float-adjusted versions to exclude shares that cannot be easily traded (e.g., those held by insiders or governments).
Equal-Weighted Indexes
Used to capture the average performance of all members. These indexes can provide more exposure to small-cap or less liquid securities. However, equal weighting results in frequent rebalancing trades as relative prices change.
Worked Example 1.1
A global equity index provider is launching a new index of 50 large technology stocks, with Apple Inc. shares trading at $160, BetaCorp at $40, and GammaTech at $8. All have the same number of shares outstanding. What happens to each company’s weight under (a) a price-weighted index, and (b) a market-cap-weighted index?
Answer:
(a) In a price-weighted index, Apple has 20× more influence than GammaTech since only price is considered. (b) In a market-cap-weighted index, all three stocks have equal weights since shares outstanding × price is the same.
Float Adjustment
Some indexes adjust market capitalizations so only public, freely tradable shares count toward weights. This prevents illiquid stocks held mostly by founders or governments from dominating the index.
Index Maintenance: Rebalancing and Reconstitution
Over time, index composition and weights drift as prices change, corporate actions occur (stock splits, M&A), or new companies qualify. Index providers periodically rebalance weights and/or reconstitute the index membership by reviewing eligibility criteria.
- Rebalancing: Adjusts weights back to target proportions. For equal-weighted indexes, this may mean selling outperformers and buying underperformers, resulting in higher turnover and transaction costs.
- Reconstitution: Adds or removes index members based on rules (e.g., dropping the smallest companies and adding new ones that have grown).
Index Construction Biases
No index is free of limitations. Construction and maintenance choices create known biases that can impact interpretation and performance.
Key Term: survivorship bias
The exclusion from a dataset or benchmark of securities that have ceased to exist due to failure, bankruptcy, or delisting, which inflates historical returns.Key Term: look-ahead bias
The use of information in constructing an index or backtest that would not have been available at the time.
Common Biases
- Survivorship bias: Past returns appear overstated as “dead” or failed companies are excluded after delisting.
- Reconstitution/turnover drag: Replacing index members can lead to buying shares after prices have already increased (momentum bias), and selling after persistent declines.
- Look-ahead bias: Backtested performance may reflect data only known in hindsight.
- Concentration risk: Market-cap-weighted indexes can become dominated by a few very large firms or sectors, distorting the intended coverage.
Worked Example 1.2
Suppose a market-cap-weighted index of biotech stocks is reconstituted every December. In 2020, only the largest 10 companies remain, while all smaller (and many failed) firms from prior years are dropped from the history. Over 10 years, the surviving members grew 500%, and the index shows strong outperformance versus a buy-and-hold basket started in 2010. Why does this comparison overstate active manager underperformance?
Answer:
The index suffers from survivorship bias. Only the winning companies remain in the calculated return series. The “true” performance would be lower if those that failed or were delisted were included; active managers holding the full universe would own both winners and losers.
Revision Tip
When comparing indexes or funds, always check for float adjustment, weighting method, rebalancing frequency, and whether survivorship bias or reconstitution rules may be inflating results. These methodological details greatly affect observed risk and return.
Summary
Index construction and weighting choices matter. Price-weighted indexes overweight high-price stocks, while market-cap weighting emphasizes the largest companies. Equal-weighted indexes democratize weightings but increase rebalancing costs and may overweight illiquid names. Survivorship bias, concentration risk, and turnover from reconstitution can lead to misleading results if not recognized. Comparing active managers or funds requires understanding these biases to set fair benchmarks and avoid faulty conclusions on true skill.
Key Point Checklist
This article has covered the following key knowledge points:
- Explain the security selection, weighting, and maintenance steps in index construction.
- Describe and compare price, market-cap, float-adjusted, and equal weighting schemes.
- Identify potential biases in indexes, including survivorship bias and reconstitution effects.
- Recognize how rebalancing and maintenance policies influence index turnover, costs, and performance.
- Interpret index return and risk characteristics in light of construction and weighting schemes.
Key Terms and Concepts
- index rebalancing
- index reconstitution
- price-weighted index
- market-cap-weighted index
- float-adjusted index
- equal-weighted index
- survivorship bias
- look-ahead bias