Behind every popular benchmark lies a method for deciding how much influence each company has. This methodology quietly shapes returns, risks and the stories we tell about the market. When analysts discuss the Sensex Index, they are referring to a free-float weighted measure in which larger companies carry more influence. Meanwhile, readers who glance at the Kospi Index in international coverage will find a similar principle at work. Understanding weighting helps investors grasp why headline numbers sometimes diverge from their personal experience.
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Understanding Free-Float Market Capitalisation
Market capitalisation refers to the total value of a company’s shares, calculated by multiplying the price of each share by the total number of shares in issue. Free-float capitalisation is a variation of this calculation in which only the traded shares – those not retained by promoters, governments and strategic investors – are used.
This is important in India, where promoter ownership tends to be high: companies with a similar market value will have a differing free-float market value, and the latter should be used as a guide to the tradable liquidity of a stock.
The Concentration Question
One consequence of using a market-value weighted index is concentration risk: if very large firms dominate the index, it is possible to be inadvertently exposed to enormous concentrations of risk.
In India, financial services, information technology and energy companies have a disproportionately large impact on several indices.
This means that if you were to purchase a mutual fund tracking one of these indices, you could find that you were indirectly exposed to outsized concentrations of risk in these firms. While big companies tend to be better run, more profitable and more liquid, this is not always the case, and the poor performance of one can damage the returns of a broadly diversified portfolio disproportionately.
Alternatives to Traditional Weighting
There are several approaches to creating a stock index besides traditional weighting by market value. One is to create an equal-weight index, in which each firm in the index has the same weight, regardless of market value.
This has advantages and drawbacks: a portfolio’s risk is more widely dispersed, but small caps have an outsized impact on returns and the whole portfolio tends to be more volatile than one weighted by size. Other approaches track factors such as quality, momentum and value, while some focus on dividends.
Each of these has its own dangers: the momentum approach tends to do particularly badly when markets become bearish, while equal weight and factor portfolios can suffer from higher short-term volatility. It is important to be diversified across different approaches.
What This Means for Your Portfolio
A good starting point in reviewing the impact of weighting structures on your portfolio is to consider the ten biggest names in any fund in which you have an interest. Consider the sectors in which they operate and the overlaps between the funds you own – it is not unusual for investors to discover that they have unwittingly concentrated their risk in a few large companies due to the way their mutual funds are structured. If you wish to remain exposed to large companies without being disproportionately exposed to any single one, consider complementing your current investments with a combination of mid-cap, small-cap and equal-weight funds.
It is also important to review these exposures on a yearly basis, as the makeup of the funds you own can change.
A similar observation applies to sectors: if financial services firms dominate both your index mutual funds and your direct stock purchases, a market correction in this sector is likely to damage your portfolio more than it otherwise would. Consider diversifying into consumer goods, healthcare and industrial firms, which tend to behave differently.
A Note on Realistic Expectations
It is important to remember that weighting structures affect returns, but do not generate returns.
The long-term prospects of any stock fund are determined by the underlying corporate earnings prospects, the valuation at which it is purchased and the discipline of the investor holding it. This final consideration is crucial: no matter how well-constructed your portfolio is, abandoning it at the first sign of trouble will destroy any potential for gains. Understanding these fundamentals is the best defence against inappropriate and costly reactions to market fluctuations.
Knowing how markets work is an important step towards understanding how your money can make money. It transforms you from a pawn of the headlines into a participant in the game, able to understand and take advantage of opportunities as they arise.
