Pathway: Portfolio Management

A cap-weighted index holds constituents in proportion to market value, so it reflects the aggregate market portfolio. A factor-based index uses transparent rules to tilt toward characteristics such as value, size, momentum, quality or low volatility, deliberately deviating from market weights to capture a factor premium.

Its rules are systematic, transparent and cheap to run like an index, but choosing which factors to tilt toward, and when, is an active decision that creates tracking error against the cap-weighted market.

First, constituent selection: which securities are eligible (market, size, liquidity, sector screens). Second, the weighting method: cap, float-adjusted cap, price, equal, or fundamental weighting.

Float adjustment counts only shares available to public investors, excluding blocks held by governments, founders or cross-holdings. That makes the index investable, since a tracker can actually buy the weights, and reduces demand pressure on thinly floated stocks.

Float-adjusted caps are $400m x 0.5 = $200m and $200m x 1.0 = $200m, so each has a weight of 200/400 = 50%. A full-cap index would weight them 66.7% and 33.3%.

Weight = price / sum of prices = 100/175, 50/175, 25/175, or about 57.1%, 28.6% and 14.3% (rounded). Company size plays no part, so the highest-priced stock dominates whatever its market value.