The Pros and Cons of Market-Cap Weighting

Market-cap weighting is a method that sets each holding's weight in an index in proportion to the 'company's size (market capitalization).' Market capitalization is simply 'share price × shares outstanding.'

The formula for a holding's weight in the index is this.

Weight (%) = (that company's market cap / the index's total market cap) × 100

For example, if the index's total market cap is 100 trillion won and company A is 10 trillion won, A's weight is 10%. In practice, many indexes reflect only the 'free float' (shares actually traded), excluding shares that aren't traded on the market, such as owner or government stakes.

Most of the flagship indexes we know — the S&P 500, the Nasdaq 100, the KOSPI — use exactly this method.

The biggest advantage of market-cap weighting is that 'it runs itself.'

First, automatic rebalancing. When a company's share price rises, its market cap grows and its index weight grows on its own. Conversely, when the price falls, the weight shrinks on its own. The manager doesn't need to buy and sell frequently.

Second, low cost and tax efficiency. Because the number of trades (turnover) is low, trading costs are low and less tax on capital gains is triggered. That's why such index funds tend to have very low fees.

Third, it represents the whole market as it is. Because it reflects 'the company sizes the market has priced' as they are, it tracks the market-average return most naturally.

The flip side of the advantage is exactly the disadvantage. The structure in which 'the weight of a stock that has risen grows' is, put differently, also a structure that 'holds more of a stock that has become expensive.'

The biggest problem is concentration risk. A handful of mega-cap firms come to drive the index's performance. In fact, the weight of the top 10 stocks in the S&P 500 was around 18% around 2015, but by 2025 it had climbed to around 40%, a record level. It's a 500-stock index, yet the top 10 came to occupy around 40% of it.

For reference, this top-10 weight was around 27% even at the peak of the dot-com bubble in 2000, so the recent figure has surpassed even that.

A prime example is the 'Magnificent 7' (Apple, Microsoft, Nvidia, Amazon, Alphabet, Meta, Tesla). These 7 stocks alone accounted for about 31% of the S&P 500's market cap as of mid-2024. In 2023, a large share of the S&P 500's total return came from these 7 stocks, and it was a structure in which the index's return would shrink greatly if you excluded them.

The alternative that tries to avoid this concentration problem is the 'equal-weight' method. It gives every holding the same weight (e.g., 0.2% each for 500 stocks) regardless of company size.

But equal weight doesn't always win. In phases where large caps lead the market, it can actually lag greatly. In fact, in the single year 2023, the equal-weight S&P 500 underperformed the market-cap-weighted version by about 12%, and cumulatively over the three years from early 2023, market-cap weighting led equal weight by around 30% — one of the widest gaps in history.

Also, equal weight requires frequent buying and selling to artificially maintain the weights, so turnover and cost/tax tend to be higher than for market-cap weighting.

In the end, there isn't one right answer; it's a trade-off. Market-cap weighting carries the advantages of low cost and market representativeness and the disadvantage of concentration risk, while equal weight carries the advantage of diversification and the disadvantages of high cost and weakness in certain phases.