# Market Capitalization-Weighted Portfolio

### Reviewed by Subject Matter Experts

Updated on May 25, 2024

## What Is a Market Capitalization-Weighted Portfolio?

A market capitalization-weighted portfolio is an investment strategy where the weight of each security is determined by its market capitalization. This approach favors larger companies, potentially increasing risk but offering diversification and low costs.

## Market Capitalization

### Definition of Market Capitalization

Market capitalization, or market cap, is a financial metric used to measure the size and value of a publicly traded company. It represents the total market value of a company's outstanding shares of stock.

### Calculation of Market Capitalization

Market capitalization is calculated by multiplying a company's share price by the number of its outstanding shares. The formula is as follows:

### Market Cap Categories

Companies are often classified into categories based on their market capitalization:

• Large-Cap Companies: Typically have a market cap of \$10 billion or more. These companies are well-established and financially stable, offering relatively lower risk and stable returns.

• Mid-Cap Companies: Generally have a market cap between \$2 billion and \$10 billion. These companies may offer a balance between growth potential and stability.

• Small-Cap Companies: Usually have a market cap of less than \$2 billion. These companies may offer higher growth potential but come with increased risk and volatility.

## Market Cap-Weighted Portfolio Construction

### Building a Market Cap-Weighted Portfolio

Constructing a market capitalization-weighted portfolio involves the following steps:

1. Identifying the Target Universe of Assets: Determine the set of assets (stocks, bonds, or other securities) to include in the portfolio, such as a specific sector or market index.
2. Calculating Individual Market Caps for Each Asset: Compute the market capitalization for each security in the target universe.
3. Determining Asset Weights Based on Market Caps: Calculate the proportionate weight of each asset in the portfolio by dividing its market cap by the total market cap of all assets in the target universe.
4. Allocating Investment Funds According to Asset Weights: Invest in each asset according to its weight in the portfolio.

### Rebalancing and Maintenance of a Market Cap-Weighted Portfolio

To maintain a market cap-weighted portfolio, periodic reviews and adjustments of asset weights are necessary. This may involve:

• Periodic Review and Adjustment of Asset Weights: Rebalance the portfolio to align with the current market capitalization of the assets, typically done quarterly or annually.

## Advantages of Market Cap-Weighted Portfolios

### Diversification

Market cap-weighted portfolios offer diversification benefits by investing in a wide range of companies with different market capitalizations.

### Low-Cost Implementation

Since market cap-weighted portfolios are often passively managed, they typically have lower fees and operational costs compared to actively managed portfolios.

### Simplicity and Ease of Management

Market cap-weighted portfolios are relatively simple to construct and manage, making them an attractive option for investors with limited time or expertise in active portfolio management.

### Representation of the Market's Overall Performance

Market cap-weighted portfolios are designed to reflect the market's overall performance, allowing investors to track and benchmark their returns against the broader market.

## Disadvantages of Market Cap-Weighted Portfolios

### Concentration Risk

Market cap-weighted portfolios tend to be heavily invested in large-cap companies, which may lead to concentration risk and underexposure to smaller, potentially higher-growth companies.

### Underrepresentation of Small-Cap and Mid-Cap Companies

Since market cap-weighted portfolios focus on large-cap companies, small-cap and mid-cap companies may need to be more represented, limiting potential growth opportunities and diversification benefits.

### Passive Investment Approach

Market cap-weighted portfolios follow a passive investment approach, which may not be suitable for investors looking to outperform the market or actively manage their investments.

### Potential for Overvaluation

Market cap-weighted portfolios may invest in overvalued companies, as their weights are determined by market capitalization, which is influenced by market sentiment and stock price movements.

## Alternatives to Market Cap-Weighted Portfolios

### Equal-Weighted Portfolios

Equal-weighted portfolios assign the same weight to each asset, regardless of market capitalization. This strategy offers increased exposure to small-cap and mid-cap companies and reduces concentration risk.

### Fundamental-Weighted Portfolios

Fundamental-weighted portfolios use fundamental metrics, such as earnings or book value, to determine asset weights. This strategy may reduce overvaluation risk and provide better exposure to undervalued companies.

### Smart Beta Strategies

Smart beta strategies combine passive and active management elements, using rules-based approaches to weight assets based on value, quality, or momentum.

### Active Portfolio Management

Active portfolio management involves selecting individual assets based on research and analysis, aiming to outperform the market or achieve specific investment objectives.

## Practical Applications and Examples

### Market Cap-Weighted Index Funds and ETFs

Market capitalization-weighted portfolios are commonly used in index funds and ETFs, including:

1. S&P 500 Index: Tracks the performance of 500 large-cap U.S. companies, weighted by market capitalization.

2. FTSE 100 Index: Represents the 100 largest UK-listed companies, weighted by market capitalization.

3. MSCI World Index: Covers developed market large- and mid-cap companies across 23 countries, weighted by market capitalization.

### Benchmarking and Performance Measurement

Market cap-weighted indices serve as benchmarks for comparing the performance of investment portfolios and funds.

### Investment Strategy for Individual Investors

Market cap-weighted portfolios offer a passive, low-cost investment strategy for individual investors seeking exposure to a broad range of assets and market segments.

## Evaluating Market Cap-Weighted Portfolios in Different Market Conditions

In addition to the previously discussed points, it is crucial to consider how market capitalization-weighted portfolios perform under various market conditions.

This section examines the potential impact of bull markets, bear markets, and periods of market volatility on market-cap-weighted portfolios.

### Bull Markets

During bull markets, when stock prices are generally rising, market cap-weighted portfolios may experience strong gains, as large-cap companies often drive the overall market performance.

However, the focus on large-cap companies may cause investors to miss out on some of the more significant gains that smaller, high-growth companies achieve.

### Bear Markets

In bear markets, characterized by declining stock prices, market cap-weighted portfolios may experience losses as the overall market suffers.

However, the allocation to large-cap companies may provide some level of downside protection, as these companies are generally more stable and financially robust than smaller companies.

### Periods of Market Volatility

During periods of increased market volatility, market cap-weighted portfolios may experience fluctuations in value, as large-cap companies can be more sensitive to market sentiment and economic conditions.

While the diversification benefits of market cap-weighted portfolios can help mitigate some of the risks associated with market volatility, investors should be prepared for potential short-term fluctuations in their portfolio value.

## Conclusion

Market capitalization-weighted portfolios offer investors a simple, low-cost, diversified investment approach. However, potential drawbacks, such as concentration risk and underexposure to smaller companies, may warrant consideration.

Investors should carefully evaluate their investment objectives and risk tolerance before choosing a portfolio strategy and consider alternative approaches if necessary.

Future trends and developments in market cap-weighted portfolios may continue to shape the investment landscape and offer new opportunities for investors.