Index Fund Weighting Problems.

I wrote this as a comment on Phil's World, in response to a very fair critisism of the weighting structure of the Dow Jones Industrial Average called Doubting The Dow.  The author, Phil Davis, has it right; price weighting is a silly way to weight an index. His factoids make for interesting reading and good conversation while bored out of your mind watching stock price numbers flash on computer screens.  I suppose you could always pull out those factoids at a market geek party.  You'd be a hit.

But please don't start plugging your ears when they mention the Dow performance on ABC News just yet.  The price weighting of the Dow makes little sense but on a short term basis it is still highly correllated with the other indices like the S&P500.  Don't get me wrong the Dow is a stupid long term benchmark for the market. 

However every index methodology has its flaws*:

Market Capitalization Weighted indices have problems because they represent the market of a country not the economy. Large Profit producers can have small weightings during a bubble in one sector.  For example Technology weighting went to 30% of the S&P weighting while the entire petroleum industy was under 9% back during the tech bubble.

Float weighted indices penalize companies with small floats but large market caps like Berkshire Hathaway.

Equal weighted indicies over represent small companies.

The NDX is cap weighted with a limit placed to reduce MSFT because it would be too big.

The most widely used Brazilian index, the Ibovespa uses a trading volume weighting.

The Wisdom Tree Funds use dividend weightings.
 
MSCI uses economic participation for sector and country weightings but float for individual shares.*

My favorite benchmark for the US is the Russell 3000, a free float weighted index of the top 3000 US based companies listed in and based in the United States. 

*These facts are from memory and my days as Head of Program Trading (the preferred way that index funds trade) at Morgan Stanley.  I have not re-checked each index calculator.  Article on the Russell Index Philosophy from IndexUniverse.com.



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