An equal-weight index gives each constituent the same weight in the index, versus a market-cap-weighted or price-weighted index, where bigger companies (or those trading at higher prices) hold a larger share of the index.
Equal weighting strives to equalize the impact of each company’s performance on the overall index. Traditional market-cap weighting tends to give bigger companies more influence over outcomes.
Equal-weight investing is a smart beta strategy that may appeal to certain types of investors more than others. This article will delve deep into equal-weight investing, including:
• What Is an Equal Weighted Index?
• How to Calculate an Equal Weighted Index.
• Advantages of Using an Equally Weighted Index.
• Disadvantages of Using an Equally Weighted Index.
What Is an Equal-Weighted Index?
A stock market index tracks the performance of a specific group of stocks or a particular sector of the market. For example, the S&P 500 Composite Stock Price Index tracks the movements of 500 companies that are recognized as leaders within their respective industries.
Stock market indices are often price-weighted or capitalization-weighted.
• In a price-weighted index, the stocks that have the highest share price carry the most weight. In a capitalization-weighted index, the stocks with the highest market capitalization carry the most weight.
• Market capitalization represents the value of a company as measured by multiplying the current share price by the total number of outstanding shares.
While some investors may wish to invest in stocks, others may be interested in mutual funds or index funds, which are like a container holding many stocks.
How Equal Weighting Works
An equal-weighted index is a stock market index that gives equal value to all the stocks that are included in it. In other words, each stock in the index has the same importance when determining the index’s value, regardless of whether the company is large or small, or how much shares are trading for.
An equally weighted index essentially puts all of the stocks included in the index on a level playing field when determining the value of the index. With a price-weighted or capitalization-weighted index, on the other hand, higher-priced stocks and larger companies tend to dominate the index’s makeup — and thereby dictate or influence the overall performance of that index.
This in turn influences the performance of corresponding index funds, which track that particular index. Because index funds mirror a benchmark index, they are considered a form of passive investing.
Most exchange traded funds (ETFs) are passive funds that also track an index. Now there are a growing number of actively managed ETFs. While equal-weight ETFs are considered a smart beta strategy, they aren’t fully passive or active in the traditional sense. These funds do track an index, but some active management is required to rebalance the fund and keep the constituents equally weighted.
Examples of Equal-Weight Funds
Equal-weight exchange-traded funds (ETFs) have grown more common as an increasing number of investors show interest in equal-weight funds. Equal weight falls under the umbrella of smart-beta strategies, which refers to any non-market-capitalization strategy.
The term “smart beta” doesn’t mean a particular strategy is better or more effective than others.
Equal-weight funds, for example, are designed to shift the weight of an index and its corresponding funds away from big cap players, which can unduly influence the performance of the index/fund. And while an equal-weight strategy may have improved fund performance in some instances, the results are inconsistent.
Here is a list of the top five equal-weight ETFs by assets under management (AUM), according to ETF.com.
1. Invesco S&P 500 Equal Weight ETF (RSP )
2. SPDR S&P Biotech (XBI )
3. SPDR S&P Oil and Gas Exploration and Production (XOP )
4. SPDR S&P Global Natural Resources ETF (GNR )
5. First Trust Cloud Computing ETF (SKYY )
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How to Calculate Equal-Weighted Index
To calculate equal weighted index, you need to know two things:
• The share price of each stock that’s included in the index
• Total number of stocks included in the index
If you’re calculating an equally weighted index value for an index that has five stocks in it, each one would be weighted 20%, regardless of its stock price or market capitalization. To find an equal-weighted index value, you would simply add the share price of each stock together, then multiply it by the weight.
So for example, say an index has five stocks priced at $100, $50, $75, $90 and $85. Each one would be weighted at 20%.
Following the formula, you would add each stock’s price together for a total of $400. You’d then multiply that by the 20% weighting to arrive at an equal-weighted value of 80.
As fund turnover occurs and new assets are exchanged for old ones, or as share prices fluctuate, the equally weighted index value must be recalculated.
The equally weighted index formula can be used to determine the value of a particular index. You may want to do this when determining which index ETF to invest in or whether it makes sense to keep a particular index mutual fund in your portfolio.
Advantages of Using an Equally Weighted Index
An index investing strategy might be preferable if you lean toward more conservative investments or you simply want exposure to a broad market index without concentrating on a handful of stocks. That’s something you’re less likely to get with mutual funds or ETFs that follow a price-weighted or capitalization-weighted index.
Here are some of the reasons to consider an equal-weighted index approach:
• An equal-weight strategy can increase diversification in your portfolio while potentially minimizing exposure to risk.
• It’s relatively easy to construct an equally weighted portfolio using index mutual funds and ETFs.
• It may appeal to value investors, since there’s less room for overpriced stocks to be overweighted and undervalued stocks to be underweighted.
• Equal-weighted indices may potentially generate better or more incremental returns over time compared to price-weighted or capitalization-weighted indices, but there are no guarantees.
Disadvantages of Using Equally Weighted Index
While there are some pros to using an equal weighted approach, it may not always be the best choice depending on your investment goals. In terms of potential drawbacks, there are two big considerations to keep in mind:
• Equal-weighted index funds or ETFs that have a higher turnover rate may carry higher expenses for investors.
There is typically a constant buying and selling of assets that goes on behind the scenes to keep an equal-weighted mutual fund or ETF in balance.
Higher turnover ratios, i.e. how often assets in the fund are swapped in and out, can lead to higher expense ratios if a fund requires more active management. The expense ratio is the price you pay to own a mutual fund or ETF annually, expressed as a percentage of the fund’s assets. The higher the expense ratio, the more of your returns you hand back each year to cover the cost of owning a particular fund.
• Equal-weighted indices can also be problematic in bear market environments, which are characterized by an overall 20% decline in stock prices. During a recession, cap-weighted funds may outperform equal-weighted funds if the fund is being carried by a few stable, larger companies.
◦ Conversely, an equal-weighted index or fund may miss out on some of the gains when markets are strong and bigger companies outperform.
| Advantages | Disadvantages |
|---|---|
| Can increase diversification | Will typically have higher costs |
| Constructing an equal-weight portfolio is straightforward | May see outsize declines in bear markets |
| Equal-weight strategies may appeal to value investors | May not realize full market gains |
| Equal-weight strategies may perform better than traditional strategies, but there are no guarantees |
The Takeaway
In an equal-weight index, each stock counts equally toward the index’s value, regardless of whether the company is large or small, or what shares are currently trading for. The same is true of any corresponding fund.
There are advantages to investing in an equal-weight index fund over a capitalization-weighted index or price-weighted index. For example, equal-weighted indices may generate better or more consistent returns. Investing in an equal-weight index may be appealing to investors who prefer a value investing strategy or who want to diversify their portfolio to minimize risk.
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FAQ
How do equal-weight ETFs work?
Like an equal-weight index, an equal-weight ETF holds the same proportion of each of its constituents, which in theory may equalize the impact of different companies’ performance.
When should you buy equal-weighted ETFs?
If you’d like to invest in a certain sector, but you don’t want to be riding the coattails of the biggest companies in that sector because you see the value in other players, you may want to consider an equal-weight ETF.
What is the equally weighted index return?
The return of an equally weighted index would be captured by the performance of an investment in a corresponding index fund or ETF. So if you invest $100 in Equal Weight Fund A, which tracks an equal weight index, and the fund goes up or down by 5%, you would see a 5% gain or loss.
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