What is an Equal-Weighted Index?
An equal-weighted index is a stock market index – comprised of a group of publicly traded companies – that invests an equal amount of money in the stock of each company that makes up the index. Thus, the performance of each company’s stock carries equal importance in determining the total value of the index.
Equal-Weighted Index vs. Capitalization-Weighted Index
The standard in the world of stock investments are indexes that give weights to investments based on the market capitalization of each company contained within the index.
Each index fund weighted by market capitalization invests more into certain companies than others. Regardless of the overall scale of companies that an index represents – small cap, mid cap, or large cap – the index is stacked heavily in favor of the largest companies in the index.
Using the S&P 500 Index as an example, a majority of the index’s value is comprised of just the top ten companies that make up the index. One can easily see from this fact that weighting the index makes a huge difference in its calculated value, and that an equal-weighted index will differ substantially from a traditional market cap weighted index.
Value and Momentum as the Difference Makers in Indexes
It’s been said by some market analysts that equally weighted indices are based on value and market capitalization weighted indices are driven by momentum. An index with equal weight in all companies must buy and sell as shares of companies increase and decrease in value, restoring the balance by buying more shares of a company with a declining share price and selling off shares when a company sees its share price rise.
In that way, the market approach of an equal-weighted index can be viewed as a contrarian one, selling shares of popular Company A while buying shares of out-of-favor Company B.
The makeup of an index weighted by market cap, on the other hand, is dictated, to a large extent, by share price momentum. When share prices for a company increase, the index retains the shares, automatically allocating more weight to the company within the index.
A fund trading the index will funnel additional cash toward such companies as more investors invest in them. The inverse is true as well. If a company’s share price drops, the index allocates less cash toward the company’s stock and accords it less weight within the index.
Equal-Weighted Indexes and the Power of the Small Business
Equal-weighted indexes, in effect, favor smaller companies by according them the same importance as large cap firms. They remove the market cap bias, giving an equal shot to every company within the index. It means that even the smallest of companies exert more power in an equal-weighted index than it would in one weighted by market capitalization.
Advantages of Equal-Weighted Index Funds
An equal-weighted index fund comes with both advantages and disadvantages relative to a market cap weighted index fund. Some of the primary pros and cons of an equal-weighted index fund are as follows:
- Equal-weighted indexes are more diversified than market capitalization-weighted indexes, and, therefore, may carry less risk
- Equal-weighted funds focus on value investing, which is considered by many market analysts and investors to be a superior investing strategy
Disadvantages of Equal-Weighted Index Funds
- Equal-weighted indexes feature a higher portfolio turnover rate, which means higher total transaction costs, and which can also result in less favorable tax treatment
- They are more vulnerable to sudden, volatile drops in value during a bear market phase (In contrast, market cap weighted funds that are more heavily invested in large cap, blue chip stocks are likely to be more stable in bear markets).
Equal-weighted indexes provide an important alternative calculation of the overall value of the market. For investors, the choice as to whether to invest in a fund that uses an equal-weighted index or a market capitalization-weighted index simply comes down to which kind of index they believe is most likely to exhibit the highest return on investment (ROI).
From 2009 through 2018, an equal-weighted index version of the S&P 500 Index consistently outperformed the standard market cap-weighted index. However, an equal-weighted index of the NASDAQ-100 Index underperformed compared to the market cap-weighted NASDAQ-100 Index over the same time period. Thus, there’s no clear or easy answer to the question, “Which is better, a market cap weighted index fund or an equal-weighted index fund?”
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