One of the distinguishing characteristics of the S&P 500 is that is weighted by market capitalization, which is determined by multiplying the price by the shares outstanding. Larger companies companies have a bigger weighting in the index.
This is different from the Dow, which is weighted exclusively by price.
But indexing by market capitalization has clearly won out. Today, indexing rules the world, thanks to the growing influence of exchange-traded funds (ETFs), which are almost exclusively based on indexes weighted by market capitalization.
Why was market capitalization used as the method for weighting indexes? It’s not the only way. You can weight indexes equally, so that all 500 stocks have an equal weighting. That’s exactly what the Guggenheim S&P Equal Weight ETF (RSP) does.
You can weight by other factors as well–there’s a whole industry, dubbed “smart beta”–that tries to do just that.
Some have been around a long time, like weighting by Growth or Value. You can also try to weight indexes by some form of dividend appreciation, as do Vanguard Dividend Appreciation (VIG) or iShares Select Dividend (DVY).
But these alternative approaches have not attracted a lot of investment. Market capitalization rules the indexing world, and the investment world.
Partly, it’s just common sense. Weighting a company just by price ignores the simple fact that more investors will own a company that has more shares, and that fact should be considered. So a stock that is priced at $20 with 100 million shares should be considered differently than a company priced at $20 with 400 million shares.
That’s what the S&P does. In that case, the company with 400 million shares will have four times the weighting of the company with only 100 million shares, assuming their price are the same.
There’s one final point: back in the old days, they calculated stock values by hand. Imagine doing that with 500 stocks! Weighting by market capitalization means you don’t have to re-weight the index unless the amount of shares change. That made it a lot easier to calculate a price back in the pre-electronic days.
