Fundamental Weighting
Some indexes are weighted by various __fundamental__ measures. Common fundamental measures include book value, cash flow, revenues, earnings, and dividends. As an investment analyst, you like to recommend some of these to your clients as a way of tracking securities that meet their needs.
You have an investor interested in receiving income rather than price appreciation from his stock portfolio. Which index listed below would be a good choice to recommend he follow?
Correct.
A dividend-yield weighted index would better meet your client's needs to track income-producing securities.
Not correct.
A dividend-yield weighted index would better suit your client's needs to track income-producing securities.
The constituent securities will have a different weighting than with price or market capitalization depending on the fundamental. A two-stock index is shown below. It is weighted on both market capitalization and on dividend yield to show the difference:
| Security | Market cap. | Market-cap weighted | Dividend yield | Dividend-yield weighted |
|----------|-------------|-------------------|----------------|----------------------------|
| A | $600M | 60% | 3% | 30% |
| B | $400M | 40% | 7% | 70% |
| Sum | 1000 | | 10 | |
Compared to market-cap weights, how would dividend-yield weights rank security B in relation to security A?
Correct.
The weight of security B rose from 40% in the market-cap weighting to 70% in the dividend-yield weighting, so it is now overweighted using the dividend-yield weights.
Incorrect.
The weight of security B rose from 40% in the market-cap weighting to 70% in the dividend-yield weighting, so it is now overweighted using the dividend-yield weights.
To summarize:
[[summary]]
You are also pleased to find other fundamental weights that suit your clients' needs like an earnings-yield weight for a growth-oriented investor. Fundamental weighting just expands your choices over price or market-capitalization weighted indexes.
A market-capitalization weighted index
A fundamentally weighted index using dividend yield
Security B would have a higher influence on the portfolio under the dividend-yield weights than under market-cap weights
Security B would be underweighted by the dividend-yield weights
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