Equity Index Question (Reading 24)

[DJS05101985]

“Paolo Caruso, the manager of the fund, says he wants to avoid benchmarks biased toward small-capitalization stocks.”

1. The type of index that would least likely address Caruso’s concern about bias is:

1. A. a price-weighted index.
2. B. a value-weighted index.
3. C. an equal-weighted index.
   C is correct. An equal-weighted index is biased toward small-cap companies.

So … I said A - not because price-weighted indices bias toward small cap stocks but rather because you don’t know what you are getting with a price-weighted index. It COULD have a small cap bias if by chance the stocks used to construct the index happened to have higher share prices for the smaller companies.
MORESO, the equal-weighted index does not intrinsically bias small cap … it is equal-weighted! Doesn’t equal mean equal - as in evenly distributed and without inherent bias?

 

[cpk123]

Market Cap weighted - large cap biased - as market cap of the larger companies is bigger than smaller companies.
An equal weighted index is “small cap biased” -

Quote:
In an equal-weighted index, all stocks are treated the same. Small companies have the same weight in the index as very large companies. An equal-weighting methodol- ogy introduces a small-company bias because such indices include many more small companies than large ones.

Price weighted - would be biased towards the highest price companies in the index. so I am really not sure when you state “not sure what you are getting”.

 

[oz001]

“It COULD have a small cap bias if by chance the stocks used to construct the index happened to have higher share prices for the smaller companies”
Valid point, but I’d go with the “least likely” wording of the question. Small cap stocks likely have lower prices
“MORESO, the equal-weighted index does not intrinsically bias small cap … it is equal-weighted! Doesn’t equal mean equal - as in evenly distributed and without inherent bias?”
In terms of absolute numbers, there are many more small cap stocks than large caps. On a cumulative basis, an equal weighted portfolio would allocate a greater % of the portfolio to smaller companies

 

[S2000magician]

oz001 wrote:”It COULD have a small cap bias if by chance the stocks used to construct the index happened to have higher share prices for the smaller companies”
Valid point, but I’d go with the “least likely” wording of the question. Small cap stocks likely have lower prices
“MORESO, the equal-weighted index does not intrinsically bias small cap … it is equal-weighted! Doesn’t equal mean equal - as in evenly distributed and without inherent bias?”
In terms of absolute numbers, there are many more small cap stocks than large caps. On a cumulative basis, an equal weighted portfolio would allocate a greater % of the portfolio to smaller companies

The bias in equally-weighted (unweighted) indices is toward more volatile stocks; small-cap stocks tend to be more volatile than large-cap stocks.

 

[DJS05101985]

oz001 wrote:
In terms of absolute numbers, there are many more small cap stocks than large caps. On a cumulative basis, an equal weighted portfolio would allocate a greater % of the portfolio to smaller companies

Ok - I understand that argument … That answers my question. Thanks for the help all.

oz001 wrote:
Small cap stocks likely have lower prices

I don’t think this is true. Are you assuming this or do you have a reference? I know, for example, Fidelity Low Priced Stock is considered a mid-cap value fund - not because they are concentrated in mid-cap but rather because they span large to small cap.