Does your index (or equities allocation) need a tune-up? Increasingly, investors are becoming aware of the inherent limitations of market capitalization weighting, which simply uses the total market value of a firm's outstanding shares as a means to weight individual components in the index. Cap weighting is the most prevalent methodology for index construction and the very same scheme used by the S&P 500® Index. However, it often results in a heavy tilt to the largest companies, discounting the performance and contribution of the smaller constituents. Such mega-cap dominance may garner little attention at times when the largest companies excel and grow more rapidly than the average stock, as in recent years. But when the momentum runs out and mega caps fall out of favor, any product built around a cap-weighted index could suffer.

Given this reality, other index approaches have come to the forefront. One of these is a simplistic equal-weighting approach, whereby the stock index allocates equally to all constituents giving no regard to size or risk. In the S&P 500 Equal Weight Index,® for example, every company’s allocation is fixed at 0.20% (quarterly). This seems to be a naive attempt at diversification. On one hand it solves for concentration risk and mitigates some of the sector and large-company biases of traditional cap weighting. But it also ratchets up the total portfolio risk profile by over-allocating to smaller companies, which historically tend to be more volatile than their large company counterparts over time.

Investing explicitly to achieve low volatility is another popular, if dubious, approach. Limiting the universe of an index solely to lower-volatility stocks can naturally result in a lower-volatility portfolio, but it hardly provides for broad diversification. Is a portfolio full of consumer staples, utilities, and other defensive sectors an ideal, all-weather approach? Maybe not.

Ultimately, we believe that volatility weighting—giving larger weights to less volatile stocks, and smaller weights to more volatile stocks—may be a more intuitive way to build an equities index. Volatility weighting aims to equalize the volatility contribution across the entire portfolio and, by consequence, equalize the risk contribution of each constituent. Equalizing risk contribution seems like a smarter objective because it gives every stock a voice and may help create a portfolio built to perform consistently over a full market cycle.

Below is a table that provides information on five popular index methodologies and summarizes their objectives and potential limitations. Choose wisely.