What you will learn
- Read index weights as exposure choices.
- Recognize that many holdings can still share the same risks.
Benchmark
A suitable benchmark matches the strategy's market, sector, currency and risk profile, and is transparent and published in advance. Performance is compared as excess return, meaning portfolio return minus benchmark return, over the same period and on the same basis, such as total return in the same currency.
Passive funds use a benchmark as the target to follow, and active funds use one as the target to beat. A poorly chosen benchmark can flatter or penalize results, for example by comparing a technology fund with a broad market index, or a portfolio's total return with an index's price return.
Index Weighting
Under cap weighting, a constituent's weight is its market value, usually adjusted for free float, divided by the total, so large companies drive the result and weights drift automatically with prices. Equal weighting gives each constituent the same weight and needs periodic rebalancing, while price weighting lets higher-priced shares count for more regardless of company size.
The scheme shapes concentration, turnover and what the index rewards: cap-weighted indexes can become dominated by a few large names, equal-weighted indexes tilt toward smaller companies and trade more, and price-weighted indexes depend on arbitrary share-price levels.
Diversification
For two assets, portfolio variance is w1²σ1² + w2²σ2² + 2w1w2ρσ1σ2, where w are weights, σ are volatilities and ρ is the correlation. The lower the correlation, the larger the reduction in volatility; at ρ = +1 there is no volatility benefit from combining them.
Diversification cannot remove market-wide (systematic) risk, and adding many similar holdings gives little extra benefit. Correlations can also rise sharply in a crisis, so the protection seen in calm periods may shrink when it is most needed.
Worked example: Three holdings need not be balanced
Illustrative: a fictional index has weights of 60%, 25% and 15%. If only the largest constituent falls 10% and the other two are unchanged, the index loses approximately 6% before rebalancing effects. A fund with three holdings is therefore not automatically evenly diversified. A different weighting rule can lead to different concentration even with the same names.
Check your understanding
What is the largest exposure in an equally weighted four-asset portfolio, ignoring price drift? Does this guarantee low risk?
Show answer and explanation
Each weight is 25%. This limits initial single-name concentration but does not eliminate common market, sector, liquidity or currency risk, especially if the assets move together.