======Modified Market-Capitalization Weighted======
Modified Market-Capitalization Weighted (also known as a 'Capped Market-Cap Index') is a type of stock market index that adjusts the standard [[market-capitalization weighted index]] approach to limit the influence of its largest companies. In a typical index, a company's weight is determined by its [[market capitalization]] (stock price x number of outstanding shares)—the bigger the company, the bigger its slice of the index pie. However, this can lead to a situation where a few mega-companies dominate, making the index's performance heavily dependent on their fortunes. A modified-weighting strategy puts a "cap," or a maximum percentage, on the weight any single company can have. If a stock grows beyond this predefined limit, its weight is trimmed back, and the excess is redistributed among the other constituents. This method seeks to provide the benefits of broad market exposure while reducing the [[concentration risk]] that comes from being too heavily invested in a handful of market darlings.
===== Why Bother Modifying? The Problem with "Pure" Market Cap =====
Imagine a party where the playlist is controlled by the most popular person in the room. If they love disco, you're getting disco all night, whether you like it or not. A pure market-cap weighted [[index fund]] or [[ETF]] works in a similar way. When a few giant stocks, like those in the technology sector, become immensely popular and valuable, their weight in the index swells.
An investor might believe they own a diversified basket of 500 companies in an [[S&P 500]] tracker, but if the top 10 companies make up 30% or more of the index's value, their portfolio's return is really being driven by the performance of just that small group. This creates a hidden risk. If those top stocks stumble, they can drag the entire index down with them, regardless of how the other 490 companies are doing. Modification is the solution designed to turn down the volume on the most popular stocks and let the other companies have their say.
===== How the "Cap" Works in Practice =====
The mechanism for modifying an index is a simple, rules-based process of trimming and reallocating. It's an automatic discipline that prevents any single company from getting too big for its britches.
  - **Step 1: Set the Limit.** The index provider (like S&P or MSCI) establishes a cap. A common cap might be 10% for a single stock and a collective cap for all stocks exceeding 5%, such as 25% of the total index.
  - **Step 2: Regular Check-ups.** The index is reviewed at set intervals, typically quarterly.
  - **Step 3: Trim and Redistribute.** During this review, if a company's weighting has grown to exceed the cap, the index methodology requires that its weight be reduced back to the limit. The capital generated from "trimming" this winner is then reallocated proportionally among all the other, smaller-weighted stocks in the index.
A famous real-world example is the [[Nasdaq-100]] index, which uses a modification process to prevent giants like Apple and Microsoft from completely overwhelming it.
===== A Value Investor's Take =====
From a [[value investing]] perspective, the modified-weighting approach has significant appeal. Legendary value investors have always warned against chasing performance and getting swept up in market manias. A pure market-cap index, by its very nature, forces you to invest more and more into stocks as they become larger and more expensive—often when they are most overvalued.
A modified or capped index introduces an element of contrarian discipline.
  * **It Forces a "Sell High" Mentality:** By automatically trimming the biggest winners, it systematically takes profits from stocks that have performed exceptionally well and may have become expensive.
  * **It Reduces "FOMO" Investing:** It prevents your portfolio from being dominated by the most popular "story stocks" of the day, which are often priced for perfection.
However, it's crucial to remember that this is //not// a substitute for true value investing. It is still a passive, formula-driven strategy that doesn't involve analyzing a company's underlying business fundamentals or its [[intrinsic value]]. Think of it as a "smarter" or more prudent form of passive investing—a compromise that allows you to track the market while mitigating one of its most significant structural flaws.
===== The Pros and Cons for Your Portfolio =====
==== The Upside ====
  * **Better Diversification:** It ensures your investment is not overly dependent on the fate of a few giant companies, reducing concentration risk.
  * **Automatic Rebalancing:** It instills a disciplined approach, forcing you to trim winners and reallocate to the rest of the field.
  * **Protects from a Tumble at the Top:** If the market leaders fall out of favor and crash, a capped index will be less affected than its uncapped counterpart.
==== The Downside ====
  * **Will Likely Lag in Mega-Cap Bull Markets:** When a bull market is being driven by a handful of soaring giants, a capped index will underperform because it is systematically selling the very stocks that are producing the biggest gains.
  * **Higher Turnover:** The regular rebalancing involves more frequent buying and selling. This can lead to slightly higher fund management costs and, in a taxable brokerage account, could result in more frequent [[capital gains tax]] distributions, which can be a drag on your net returns.