Fundamental Weight Index

Definition

The term fundamental weight refers to a specific approach used in the calculation of a market index. With a fundamental weight index, an economic factor such as revenues or net income determines the equity's influence on the index.

Explanation

Also referred to as a stock market index, an equity index is a sample of equities, or common stocks, which are used as a benchmark when comparing the performance of a smaller set of equities or an individual stock. The method used to determine how an index is calculated is important for the investor-analyst to understand, since it provides insights into the significance of the index's movement over time.

If an index is calculated using the fundamental weight approach, a single factor, or a combination of fundamental factors determines that security's influence, or effect on, the movement of the index. The common stock of a company with strong and improving fundamentals will cause the index to move to a greater extent than a weak or weakening company. Typical fundamental factors are those that might be used in corporate valuation such as revenues / sales, book value, dividends, cash flow or earnings.

One of the benefits of a fundamental index is the approach can help negate a bias caused by one sector, especially if only one factor is used in the calculation. For example, fundamental factors are typically used to derive a company's intrinsic value, whereby an index based on capital weight also assigns extrinsic value to the index. Proponents of this approach point to the fact the weight is based on a quantifiable measure of the company's performance. Critics claim the approach is too complex and requires the investor to understand how the index is calculated.

The S&P 500 Value Index is an example of a fundamental weight index.

Related Terms

capitalization weight indexequity, index weighting, equity index, price weight index