Most exchange-traded funds, or ETFs, are passively traded. This means that the stocks that are included in an index are selected using an automated process according to one or more characteristics of the current market.
An index serves as an underlying benchmark for some exchange-traded funds (ETF.) Consequently, your ETF investing strategy will benefit from an understanding of the different types of indexes, such as the price-weighted vs value-weighted indexes. It's also helpful to explore the difference between price-weighted index and value-weighted index characteristics.
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The Price-Weighted Index
The index trading price for a price-weighted index is based on the market prices of the individual stocks, or components, that are included in the index basket. Stocks that are assigned the greater weight are those with the highest price per share.
The stocks that will influence an increase in a price-weighted index are, as expected, those stocks with higher prices. The reason being is that the index assigns a greater weight to a stock whose price is higher.
Stock Price Influence on PWI
The selection of price as the index-weighting factor means that, even if the market price of two stocks increases by the same amount over time, the stock with the highest price will have a greater influence on a price-weighted index. The Dow Jones Industrial Average is one such price-weighted index. The Dow consists of 30 components.
Example of Price Influence on Price-Weighted Index
For instance, assume a price-weighted index includes stock issued by the companies XYZ and ABC. Also, assume that on March 31, the two stocks trade at $150 and $50, respectively. Next, assume that on June 31, the share price of XYZ is $200 and the market price of ABC is $100.
In this case, the price-weighted index will continue to assign the greater weight to the XYZ stock, rather than the ABC stock. This is true despite the fact that the price of the ABC stock increased by 100 percent, while the price of XYZ increased only 25 percent.
The reason being is that a price-weighted index assigns a greater weight to the higher-priced stocks. The index ignores the relative increase amounts.
Consider this: Purpose of Indexes in Stock Market
The Value-Weighted Index
The index trading price for a value-weighted index is based on the market prices of the individual stocks, or components, as well as the number of shares of each of the stocks that are included in the index basket. Stocks that are assigned the greater weight are those with the highest price per share and the greater number of shares.
The stock that will influence an increase in a value-weighted index to the greatest extent is a stock with a high price and a greater number of shares in the index basket.
Stock Price and Quantity Influence on Value-Weighted Index
The selection of price and quantity as the index weighting factors means that, even if the market price or quantity of a stock is higher than that of any other stock in the basket, the stock with both a higher price and higher quantity will have a greater influence on a value-weighted index.As previously stated, the Dow Jones Industrial Average is one such value-weighted index.
Consider this: Does Inclusion in an Index Increase the price of a Stock?
Example of Price and Volume Influence on VWI
For instance, assume a value-weighted index includes stock issued by the companies XYZ and ABC. Also, assume that on March 31, the two stocks trade at $150 each, Next, assume that the basket includes 200 shares of XYZ, but only 100 shares of ABC.
Because XYZ stock's weight is equal to 200 shares multiplied by $150 price per share, or $30,000, versus the ABC stock's weight of $150 per share multiplied by 100 shares, or 15,000 shares, XYZ is assigned the greater weight.
This is true despite the fact that the price of the ABC and XYZ stock is the same. The deciding factors, in this case, are that the index ranks stocks according to price and quantity, and the index includes more shares of XYZ stock than of ABC stock.