The index rose, so why did most of my stocks fall?
On a day when the headline index rises 1%, many investors find most of their own stocks down. Because most major indexes are weighted by market capitalization, a few large companies rising sharply can lift the index even when most stocks fall.
Here we cover how market-cap-weighted indexes are calculated, why they are adjusted for free float, how concentration in large stocks affects them, and how periodic changes work, using a hypothetical index. It also covers how to read an index methodology.
How cap weighting works
In a cap-weighted index, each stock's weight equals its market cap divided by the total market cap of all stocks in the index. Bigger companies have bigger weights, so their price moves have more influence on the index.
ETFs that track the index hold stocks in the same proportions. As the SEC's investor bulletin on mutual funds and ETFs explains, index funds aim to match the return of their index, so the index's weighting method determines what the ETF actually owns and in what amounts.
A hypothetical index
The table shows a hypothetical five-stock index, with weights by total market cap and by float-adjusted market cap, which excludes shares not available to trade, such as large insider holdings. Company B is assumed to have only 40% of its shares in free float.
| Stock | Market cap | Cap weight | Free float | Float-adjusted cap | Float-adjusted weight |
|---|---|---|---|---|---|
| A | 500 | 50.0% | 100% | 500 | 61.0% |
| B | 300 | 30.0% | 40% | 120 | 14.6% |
| C | 100 | 10.0% | 100% | 100 | 12.2% |
| D | 60 | 6.0% | 100% | 60 | 7.3% |
| E | 40 | 4.0% | 100% | 40 | 4.9% |
Float adjustment cuts B's weight from 30% to 14.6% and lifts A's to 61%. In this index, a 10% rise in A alone, with everything else flat, moves the index up about 6.1%.
Prices and share counts
In a cap-weighted index, a stock's weight rises automatically as its price rises. Winners gain weight and laggards lose it without any trading, which is one reason index funds trade relatively little.
When share counts change through offerings, buybacks, or mergers, the index provider adjusts the index divisor so the event itself does not make the index jump. Those adjustments keep the index reflecting market price changes only.
Concentration in large stocks
Cap weighting means the largest few companies make up a large share of the index. In the example, A alone is 61% on a float-adjusted basis; in real markets, the top handful of stocks commonly account for 30% to 40% or more of a major index.
Buying an index ETF can feel like broad diversification, but results may depend heavily on a few large stocks. Some indexes cap any single stock's weight. Alternative approaches such as equal weighting behave differently, and the SEC's bulletin on smart beta funds explains why their methodology deserves separate attention.
A practical way to see this is to add up the weight of the top five holdings in any broad index fund you own. That one number shows how much of your "market" exposure is really exposure to a few companies.
Periodic changes
Indexes are typically reconstituted or rebalanced once or twice a year, or quarterly. Stocks that no longer meet size or liquidity rules are removed, and newly eligible stocks are added, usually with several weeks' notice.
Because funds tracking the index must buy additions and sell deletions on the effective date, those stocks can move sharply around the announcement and the change date. The rules and schedule are set out in the index provider's published methodology documents.
Reading an index methodology
Before investing in a product that tracks an index, check the provider's materials and the fund's prospectus on EDGAR.
- Identify the weighting method (market cap, float-adjusted cap, equal weight, or other) and the number of stocks.
- Check whether there is a cap on any single stock's weight, and at what level.
- Look at the current top ten holdings, their combined weight, and sector weights.
- Note how often the index is reconstituted and the criteria for adding and removing stocks.
- In the ETF's documents, check how closely the fund has tracked the index.
Limits of reading an index
A cap-weighted index captures the change in total market value well but says little about how the typical stock performed. Judging the market's mood by the index alone can differ from what most investors experience.
The index calculation here is hypothetical. When you study a real index, use the provider's latest methodology and constituent data with their dates, and pair index returns with breadth measures such as the number of advancing and declining stocks.