Level III Core · Overview of Equity Portfolio Management

Equity Indexes and Benchmark Selection for CFA Level III

Updated 8 October 2026 · Fact-checked

An equity index is a rules-based basket of securities. Its weighting method (market cap, float-adjusted, equal, fundamental) sets what you own and your risk. To pick a benchmark, check that it matches the portfolio's style, universe and objectives, and that it meets the qualities of a valid benchmark.

Understand Equity Indexes and Benchmark Selection

An equity index is a rule-based list of securities with weights. The rules cover three things: which securities are eligible (the universe), how each security is weighted, and how often the index is reviewed and rebalanced. Different rules give different returns and risks, even for the same stocks.

The main weighting methods are:

Price weighted: weight is proportional to share price. High-priced stocks dominate, and a stock split changes weights. Weights have no link to company size.
Equal weighted: every stock gets the same weight. It tilts toward small caps and needs frequent rebalancing (selling winners, buying losers), so turnover and trading costs are higher.
Market-capitalization weighted: weight is proportional to price × shares outstanding. It is the most common method. It needs little rebalancing, but it overweights stocks that have risen and may be overvalued.
Float-adjusted market-cap weighted: same as market cap, but only shares available to public investors count. Shares held by governments, founders or strategic holders are excluded. This is more investable and is the standard for most broad indexes.
Fundamental weighted: weights follow company size measures such as sales, earnings, book value or dividends. This breaks the link between weight and price. It introduces a value tilt and uses rules that need periodic rebalancing.

A benchmark is the yardstick for judging a portfolio and the reference for risk. At Level III, you must decide whether a given index is an appropriate benchmark. A valid benchmark has eight qualities. It is unambiguous, investable, measurable, appropriate, reflective of current investment opinions, specified in advance, accountable and owned by the investment manager. Check that the index holdings match the manager's style and universe, that its risk is similar to the portfolio's, and that the manager has current views on the securities in it, so those views can show up as differences from it. Always tie your choice to the client's objectives and constraints, such as the mandate, the currency and any restrictions.

When no single index fits, you can use a custom benchmark, a blend of indexes or a rebuilt index built from the manager's actual universe and style. Check fit using holdings-based and returns-based comparisons: style, market cap, sector weights, valuation measures and correlation of returns with the index.

Key rules to remember

Market-cap weight: wᵢ = (Pᵢ × Sharesᵢ) ÷ Σ(Pⱼ × Sharesⱼ); Uses all shares outstanding. Weights sum to 100%.
Float-adjusted weight: wᵢ = (Pᵢ × Float sharesᵢ) ÷ Σ(Pⱼ × Float sharesⱼ); Float shares exclude strategic, insider and government holdings.
Equal weight: wᵢ = 1 ÷ N; N is the number of constituents. Weights drift and must be reset at each rebalance.
Price-weighted weight: wᵢ = Pᵢ ÷ Σ Pⱼ; Based on price only, not company size.
Fundamental weight: wᵢ = Fundamentalᵢ ÷ Σ Fundamentalⱼ; Fundamental is sales, earnings, book value, dividends or a blend.
Qualities of a valid benchmark: Unambiguous, investable, measurable, appropriate, reflective of current investment opinions, specified in advance, accountable, owned by the investment manager; Use this eight-item list as a checklist when judging a benchmark.

How to solve Equity Indexes and Benchmark Selection questions

Use this method for any question on index construction or benchmark choice.

1Read the command word and the client or mandate details. Note style, universe, constraints and objective.
2Identify the index weighting method from the description (price, equal, market cap, float, fundamental).
3If asked for weights, compute the weighting measure for each stock, sum them, then divide each by the total. Show each step.
4Link the method to its effect: concentration, size or value tilt, turnover, capacity and rebalancing.
5If choosing a benchmark, test it against the qualities list and the manager's actual holdings and style.
6State the conclusion first, in one sentence, then give the supporting reasons in the fewest words that earn the points.
7Check that you answered exactly what was asked and gave the number of reasons requested.

Quickest way: Weight and fit in 60 seconds

When to use it: Use when a vignette asks which index or weighting fits a manager or client and you have little time.

Name the weighting method in one word.
Ask: what does it overweight? (Price: high-priced stocks. Cap: large and risen stocks. Equal: small caps. Fundamental: a value tilt, meaning stocks with large fundamentals relative to price.)
Match that tilt to the manager's style and the client's constraint.
Reject any option that fails investability or style match.
Pick the best fit and state one reason.

Common mistakes in Equity Indexes and Benchmark Selection

Weighting by market cap when the question says float-adjusted.
Candidates skip the free float data in the table.
Fix: Underline the word 'float' and use float shares to compute value and weights.
Saying equal weighting needs less trading than market-cap weighting.
Equal weights look simple.
Fix: Equal weights drift as prices move, so rebalancing means more turnover and cost.
Claiming fundamental weighting avoids all valuation bias.
It ignores price, so it sounds neutral.
Fix: Say it reduces price-driven overweighting of expensive stocks but adds a value tilt and depends on the fundamental chosen.
Picking a benchmark by popularity or by the highest past return.
Broad well-known indexes feel safe.
Fix: Judge the benchmark on style fit, investability and the qualities checklist, not on fame or past performance.
Giving more or fewer reasons than asked.
Candidates try to cover everything.
Fix: Count the responses requested. Only that number, in the order given, is evaluated.
Forgetting that a price-weighted index changes weights after a split.
Weights seem fixed by the company.
Fix: Remember weight depends on price, so a split lowers that stock's weight unless the index adjusts.

Worked examples

Example 1

An index has three stocks. A: price 50, 100 shares outstanding, 80 float shares. B: price 20, 400 shares outstanding, 400 float shares. C: price 10, 300 shares outstanding, 150 float shares. Compute the weight of stock A in a market-cap weighted index and in a float-adjusted index.

Show the solution

Market cap of A = 50 × 100 = 5,000.
Market cap of B = 20 × 400 = 8,000.
Market cap of C = 10 × 300 = 3,000.
Total market cap = 5,000 + 8,000 + 3,000 = 16,000.
Weight of A (market cap) = 5,000 ÷ 16,000 = 31.25%.
Float value of A = 50 × 80 = 4,000.
Float value of B = 20 × 400 = 8,000.
Float value of C = 10 × 150 = 1,500.
Total float value = 4,000 + 8,000 + 1,500 = 13,500.
Weight of A (float) = 4,000 ÷ 13,500 = 29.63%.

Answer: Stock A has a weight of 31.25% in the market-cap index and 29.63% in the float-adjusted index.

Example 2

A manager runs a global portfolio of small-cap value stocks with low turnover. The client proposes a broad large-cap market-cap weighted index as the benchmark. Recommend whether to accept it, and justify in two reasons.

Show the solution

Decision: do not accept it.
Reason 1: it is not appropriate. Its holdings are large caps, while the portfolio holds small-cap value stocks, so style and size do not match.
Reason 2: the difference in risk and return would reflect the style mismatch, not the manager's skill, so it fails to measure skill and the manager could not be held accountable.
Alternative: use a small-cap value index, or a custom benchmark built from the manager's actual universe, specified in advance and investable.

Answer: Reject the large-cap index because it does not match the manager's size and style, and it would measure style differences instead of skill. Use a small-cap value or custom benchmark.

Exam tips

Practise weight calculations with float shares. Show each stock's value, the total, then the weight, so a slip still earns method credit.
Learn one tilt per weighting method. Exam questions often ask what a method overweights.
For benchmark questions, tie the answer to the mandate in the vignette. Generic checklist answers earn fewer points.
Read the command word. 'Justify' needs a reason, 'identify' needs only a name.
For item sets, eliminate options that fail investability or style fit before comparing the rest.

Equity Indexes and Benchmark Selection: frequently asked questions

What is the difference between market-cap weighted and equal weighted indexes?

A market-cap index weights each stock by its share of total market value, so large companies dominate. An equal-weighted index gives every stock the same weight, so it tilts to smaller companies. Equal weighting needs more rebalancing and has higher turnover.

Why use a float-adjusted index instead of a full market-cap index?

Float adjustment counts only shares that public investors can actually trade. This makes the index more investable and avoids overweighting companies with large locked-in holdings.

What is a fundamental weighted index?

It weights stocks by measures such as sales, earnings, book value or dividends instead of price. This reduces the link between weight and price and usually adds a value tilt.

How do I choose a benchmark for an equity portfolio?

Check that the index matches the portfolio's style, size and universe, and meets all eight valid-benchmark qualities: unambiguous, investable, measurable, appropriate, reflective of current investment opinions, specified in advance, accountable and owned by the investment manager. Compare holdings and returns to confirm the fit, and use a custom benchmark if no index fits.