Equal weighted index

What Is an Equal Weighted Index?

An equal weighted index is a type of stock market index where each constituent security is assigned the same weight or proportion, regardless of its market capitalization. This approach falls under Index Construction Methodologies, providing a distinct way to measure market performance compared to more common weighting schemes. In an equal weighted index, if there are 100 stocks, each stock would represent 1% of the index's total value at the time of [rebalancing]. This method inherently offers greater [diversification] by reducing the influence of a few dominant [large-cap] companies and increasing exposure to [small-cap] and [mid-cap] companies. Consequently, an equal weighted index can present a different risk-return profile within a [portfolio] compared to other index types.

History and Origin

While the concept of assigning equal importance to components within a group is intuitive, the formalization and widespread adoption of equal weighted indexes in investment products are relatively modern. Traditionally, most major market indexes, such as the S&P 500, were constructed using a market-capitalization weighting scheme. However, as investors sought alternative approaches to benchmark performance and manage [concentration risk], equal weighting gained traction. A notable development in this area was the launch of the S&P 500 Equal Weight Index on January 8, 2003, by S&P Dow Jones Indices. This marked a significant moment, providing an accessible and investable equal-weight version of a widely recognized broad market index¹⁶. The introduction of such benchmarks pioneered the development of other non-capitalization weighted indexes, catering to investors who began questioning the efficiency assumptions embedded in traditional market-cap weighting¹⁵.

Key Takeaways

• An equal weighted index assigns the same weight to each component, irrespective of its size or market value.
• This weighting scheme reduces the influence of the largest companies, providing greater exposure to smaller and mid-sized firms within the index.
• Periodic [rebalancing] is necessary to maintain equal weights as asset prices fluctuate, which can lead to higher [transaction costs] and portfolio turnover.
• Equal weighted indexes may offer different performance characteristics, potentially exhibiting a value tilt and a bias toward smaller companies.
• They serve as an alternative [investment strategy] for investors seeking broader [diversification] and reduced dependence on mega-cap stocks.

Formula and Calculation

The calculation of an equal weighted index is straightforward. Each component asset is given an identical weight. To find the index value at any given time, the sum of the prices of all constituent stocks is typically used, then adjusted by a divisor to maintain continuity across corporate actions (like stock splits or dividends) and index changes.

For an index with (N) constituent stocks, the weight of each stock (i) at rebalancing is:

The index value (IV) can be conceptualized as:

Where:

• (P_i) = Price of stock (i)
• (N) = Total number of stocks in the index
• (D) = Divisor (an adjustment factor that ensures continuity of the index value when constituents change or corporate actions occur, similar to how a price-weighted index might handle such events).

After rebalancing, if a stock's price increases, its weight in the portfolio will naturally increase beyond (1/N). To return to equal weighting, shares of the outperforming stock must be sold, and shares of underperforming stocks must be purchased, a process intrinsic to [rebalancing].

Interpreting the Equal Weighted Index

Interpreting an equal weighted index involves understanding its inherent biases and how these influence its performance relative to other index methodologies. Because each constituent has an equal say, the index's performance is not dominated by the largest companies, as is often the case with a [market-capitalization weighted index]. This means an equal weighted index can reflect the performance of the broader market more evenly across its components.

An equal weighted index implicitly overweights [small-cap] and [mid-cap] companies compared to their proportional representation in the overall market by value, and underweights [large-cap] companies. This structural difference can lead to periods of outperformance or underperformance, depending on which market segments are leading. Investors might interpret strong performance from an equal weighted index as an indication of a robust broader market, where growth is more distributed among companies rather than concentrated in a few mega-caps. Conversely, during periods when large companies significantly outperform smaller ones, an equal weighted index may lag. Its composition also naturally lends itself to a [value investing] approach, as the periodic rebalancing involves selling securities that have grown larger (and thus become relatively more expensive) and buying those that have become smaller (and thus relatively cheaper)¹⁴.

Hypothetical Example

Consider a hypothetical equal weighted index composed of just three companies: Company A, Company B, and Company C.

Initial Index Value (Day 1):

• Company A: Share Price = $100
• Company B: Share Price = $50
• Company C: Share Price = $75

Since this is an equal weighted index with three components, each company will represent 1/3 or approximately 33.33% of the index's total value.

Total initial value of the stocks for calculation purposes (assuming a starting divisor of 1 for simplicity):
$100 + $50 + $75 = $225

Suppose after one quarter, their prices change:

• Company A: $120 (up 20%)
• Company B: $40 (down 20%)
• Company C: $80 (up 6.67%)

New sum of prices = $120 + $40 + $80 = $240.

To maintain the equal weighting, the index would undergo [rebalancing]. This involves selling some shares of Company A and Company C, and buying more shares of Company B, so that each again represents approximately 33.33% of the portfolio's value. This regular adjustment is a key characteristic that distinguishes an equal weighted approach and is crucial for maintaining the intended [asset allocation].

Practical Applications

Equal weighted indexes are primarily used by investors seeking a different exposure to market segments than provided by traditional market-capitalization weighted indexes. One of the most common applications is through [exchange-traded fund] (ETF) products. These ETFs track specific equal weighted benchmarks, offering investors a simple way to gain diversified exposure.

For instance, the Invesco S&P 500 Equal Weight ETF (RSP) tracks an equal weighted version of the S&P 500, where each of the 500 companies holds approximately a 0.2% weight¹³. Other examples include the Invesco Russell 1000 Equal Weight ETF (EQAL) and the First Trust Nasdaq-100 Equal Weighted Index (QQEW). These products are often incorporated into a broader [passive investing] strategy for investors aiming to reduce [concentration risk] and potentially capitalize on the performance of smaller companies that might be overlooked in cap-weighted benchmarks. Academic research has also explored the long-term performance of equal-weighted portfolios, with some studies suggesting potential for higher risk-adjusted returns compared to cap-weighted counterparts over certain periods¹².

Limitations and Criticisms

While an equal weighted index offers distinct advantages, it also has limitations and faces criticisms. A primary concern is the increased [transaction costs] due to frequent [rebalancing]. As stock prices fluctuate, the equal weighting is disturbed, necessitating regular buying and selling to restore the target weights. This higher portfolio turnover can lead to increased trading expenses and potential tax implications for investors in actual equal funds, though some research suggests these costs may not always negate the performance benefits¹¹.

Another criticism is that an equal weighted index implicitly takes a contrarian position by consistently selling winners and buying losers during rebalancing⁹, ¹⁰. While this can align with a [value investing] philosophy, it can also mean missing out on the continued strong performance of market-leading companies during extended bull markets where growth is concentrated. The structural bias towards [small-cap] and [mid-cap] stocks also means that an equal weighted index may exhibit higher volatility compared to a [market-capitalization weighted index] dominated by more stable, [large-cap] companies⁷, ⁸. This characteristic means that while an equal weighted index might fall more severely during market downturns, it could also rebound more strongly during bull markets⁶.

Equal Weighted Index vs. Market-Capitalization Weighted Index

The fundamental difference between an equal weighted index and a [market-capitalization weighted index] lies in how they assign importance to their constituent securities.

While a market-capitalization weighted index reflects the total value of the market, an equal weighted index offers a different perspective by giving every company equal influence on the index's performance. The choice between these methodologies often depends on an investor's [investment strategy] and outlook on market dynamics.

FAQs

How does rebalancing affect an equal weighted index?

[Rebalancing] is crucial for an equal weighted index. It's the process of periodically adjusting the portfolio to restore the equal weight of each constituent. For example, if a stock performs well, its weight in the index will naturally increase. To bring it back to its original equal weight, some shares of that stock are sold, and shares of underperforming stocks are bought. This ensures that the index continues to reflect the equal importance of all its components. This process can lead to higher [transaction costs] and increased portfolio turnover compared to other index types.

Can an equal weighted index outperform a market-capitalization weighted index?

Historically, an equal weighted index has shown periods of outperformance compared to a [market-capitalization weighted index], particularly over the long term, though this is not guaranteed.⁴, ⁵ This potential outperformance is often attributed to the equal weighted index's greater exposure to [small-cap] and [mid-cap] stocks, which can have higher growth potential, and the implicit contrarian [investment strategy] of regularly buying low and selling high through rebalancing.², ³ However, there have also been periods of underperformance, especially when large-cap growth stocks lead the market.¹

Are equal weighted ETFs suitable for all investors?

Equal weighted [exchange-traded fund] (ETFs) can be a valuable component of a diversified [portfolio], especially for investors seeking to reduce [concentration risk] and gain broader exposure to smaller companies within an index. However, they typically entail higher [transaction costs] due to their frequent rebalancing schedule and may exhibit higher volatility compared to market-capitalization weighted alternatives. Investors should consider their individual risk tolerance, investment horizon, and overall [asset allocation] before incorporating equal weighted ETFs into their investment plan.