A capped index is a measurement of some type of market that is not skewed by the size of certain components within that market. Like other indices, it is made up of an average of the performance of the individual components within it, such as stocks or other securities. The difference with a capped index is that, while it might be weighted to reflect bigger players in the market, it cannot overly favor those bigger players. It does this by capping the weight that any one individual component has when computing the average of all the components together.
Indices are used in a variety of ways by market analysts and investors alike. The idea behind a market index is to take a bunch of similar securities, like stocks, and average the performance of these securities over time. As the average rises and falls, analysts can get a good idea off how certain market sectors are performing. Investors are interested in this if they are choosing securities by sector or if they are investing in funds that are set up to mirror a certain index. A capped index prevents one security from being weighted too heavily in an overall average.
To understand how a capped index works, it is important to first understand the concept of a weighted index. A weighted index is so named because it skews the average more toward the securities that have more impact on the overall market. For example, if a certain stock has a market capitalization that makes up 50 percent of all the market capitalization of the stocks included in an index, the index would reflect that dominance when the average was computed.
The difference with a capped index is that one security may be limited to the amount of impact that it can have on the measurement of the entire index. For example, a certain stock index may have a cap of 20 percent. That means that even a stock with a higher market capitalization than that could not exceed 20 percent of the weighted average.
By using a capped index, there is no single stock or other security that can weigh down an index too heavily. This is done so that a more balanced overview of an entire market might be gained from the index. Just because one security takes up a large portion of a market and is performing in a certain manner, it doesn't necessarily mean that the rest of the market is performing in that fashion as well. Capping an index gives a picture more reflective of the actual state of some market sector.