Equally weighted index

What Is an Equally Weighted Index?

An equally weighted index is a type of market index in which all component securities are assigned the same weight, regardless of their market capitalization or other metrics. This contrasts with more common approaches, such as market-capitalization-weighted indexes, where larger companies have a greater influence on the index's performance. The equally weighted index falls under the broader financial category of portfolio theory. By giving each constituent an identical allocation, an equally weighted index aims to provide a more diversified representation of the underlying market or segment, reducing the concentration risk inherent in market-cap-weighted alternatives.

History and Origin

The concept of equally weighting assets in a portfolio or index isn't new, aligning with simple diversification principles. However, the formalization and widespread adoption of equally weighted indexes in financial products are more recent. A notable example is the S&P 500 Equal Weight Index (EWI), which was launched on January 8, 2003, with back-tested data extending to December 31, 1970.¹⁷ This index tracks the same 500 companies as the traditional S&P 500, but each company is given a fixed weight, typically 0.2% (1/500th) of the index total, and is rebalanced quarterly to maintain these equal proportions.¹⁶ This development provided investors with a practical vehicle to gain exposure to a broad market index without the concentration towards large-cap companies that characterizes market-cap-weighted indexes.

Key Takeaways

• An equally weighted index assigns the same weight to each of its constituent securities.
• It aims to reduce concentration risk by giving smaller companies a proportionally larger influence than in market-capitalization-weighted indexes.
• Rebalancing is a key feature, as the index must be adjusted periodically to restore equal weights after market fluctuations.
• Equally weighted indexes may incur higher transaction costs due to more frequent rebalancing.
• Historically, some equally weighted indexes have shown periods of outperformance compared to their market-cap-weighted counterparts, particularly in certain market environments.

Formula and Calculation

The calculation for an equally weighted index is straightforward. Each security in the index is assigned a weight of (1/N), where (N) is the total number of securities in the index.

Let:

• (W_i) = Weight of individual security (i)
• (N) = Total number of securities in the index

The formula for the weight of each security is:

The index value itself is typically calculated by summing the prices of the component securities, adjusting for any stock splits or dividends, and dividing by a divisor to maintain continuity. However, the core principle of equal weighting applies to the proportion of the index's total value allocated to each security. After market movements, securities that have performed well will have a higher weight, and those that have performed poorly will have a lower weight. The index is then rebalanced (often quarterly) to bring each security back to its (1/N) weight. This rebalancing involves selling portions of outperforming assets and buying more of underperforming assets. This systematic process is a form of value investing and contributes to the index's performance.

Interpreting the Equally Weighted Index

Interpreting an equally weighted index involves understanding its inherent biases and how it diverges from traditional market-cap-weighted benchmarks. Because each stock holds the same weight, an equally weighted index inherently has a greater exposure to small-cap stocks and mid-cap stocks compared to a market-cap-weighted index, where larger companies dominate. For example, in the S&P 500, the largest companies can collectively account for a significant portion of the index's value, while in an equally weighted S&P 500 index, each of the 500 companies contributes only 0.2%.¹⁵

This means that the performance of an equally weighted index is less influenced by the movements of a few mega-cap companies. Instead, it reflects the aggregate performance of all its constituents more evenly. Investors might use an equally weighted index to gauge the performance of the broader market without the skew introduced by market capitalization. It can also be seen as a proxy for a portfolio with a stronger tilt toward smaller, potentially more growth-oriented companies, or those that might be considered undervalued securities.

Hypothetical Example

Consider a hypothetical equally weighted index consisting of just three stocks: Company A, Company B, and Company C.

Initial State (Day 1):

• Company A: Price = $100, Weight = 33.33%
• Company B: Price = $50, Weight = 33.33%
• Company C: Price = $200, Weight = 33.33%

Let's assume the total initial value of a portfolio tracking this index is $3,500.

• Investment in Company A: $3,500 * 0.3333 = $1,166.55 (approximately 11.66 units)
• Investment in Company B: $3,500 * 0.3333 = $1,166.55 (approximately 23.33 units)
• Investment in Company C: $3,500 * 0.3333 = $1,166.55 (approximately 5.83 units)

Market Movement (Day 2):

• Company A: Price increases to $110
• Company B: Price decreases to $45
• Company C: Price remains at $200

Now, the individual values in the portfolio are:

• Company A: 11.66 units * $110 = $1,282.60
• Company B: 23.33 units * $45 = $1,049.85
• Company C: 5.83 units * $200 = $1,166.00

The total portfolio value is now $1,282.60 + $1,049.85 + $1,166.00 = $3,498.45.
The new weights are:

• Company A: $1,282.60 / $3,498.45 = 36.66%
• Company B: $1,049.85 / $3,498.45 = 30.01%
• Company C: $1,166.00 / $3,498.45 = 33.33%

Rebalancing (End of Quarter):

To rebalance the equally weighted index, the portfolio manager would sell enough of Company A to bring its weight back to 33.33% and buy more of Company B to bring its weight back to 33.33%. Company C would remain at its target weight. This periodic rebalancing mechanism is what drives the unique return characteristics of an equally weighted index, potentially capturing the rebalancing bonus.

Practical Applications

Equally weighted indexes have several practical applications in investing and portfolio construction:

• Exchange-Traded Funds (ETFs): Many ETFs are designed to track equally weighted indexes, offering investors an accessible way to gain exposure to this strategy. For example, the Invesco S&P 500 Equal Weight ETF (RSP) tracks the S&P 500 Equal Weight Index.¹⁴ These products allow for immediate diversification across the index's constituents.
• Active Management Alternative: For investors concerned about the concentration of market-cap-weighted indexes in a few large companies, an equally weighted index can serve as an alternative that offers broader exposure to the underlying market without explicit active stock selection.
• Academic Research and Analysis: Researchers often use equally weighted indexes to study market behavior, assess factor performance, and compare different weighting schemes, as they can reveal insights into market dynamics that might be obscured by market capitalization biases.
• Risk Management: By spreading exposure evenly across all constituents, equally weighted indexes can help mitigate idiosyncratic risk associated with the poor performance of a few dominant companies.
• Smart Beta Strategies: Equally weighted indexing is considered one of the earliest forms of "smart beta" or factor investing strategies, as it implicitly tilts a portfolio towards smaller companies and often a value factor, which have historically demonstrated periods of outperformance. Morningstar's Director of Global Passive Research, Ben Johnson, has discussed various index-weighting approaches, including equally weighted indices, in the context of their implications for investors.¹⁰, ¹¹, ¹², ¹³

Limitations and Criticisms

Despite their appeal, equally weighted indexes come with certain limitations and criticisms:

• Higher Turnover and Costs: The most significant drawback is the higher portfolio turnover. To maintain equal weights, the index must be rebalanced frequently (e.g., quarterly). This involves selling portions of securities that have risen in value and buying more of those that have fallen. This active rebalancing leads to higher brokerage commissions and potential tax implications for taxable accounts. For instance, the S&P 500 Equal Weighted index has had significantly higher annualized turnover compared to the market-cap-weighted S&P 500.⁸, ⁹
• Small-Cap and Value Tilt: While sometimes viewed as a benefit, the inherent tilt towards smaller companies and, at times, a value factor can also be a limitation. If small-cap or value stocks underperform, the equally weighted index may lag its market-cap-weighted counterpart.⁶, ⁷
• Lack of Economic Representation: Critics argue that an equally weighted index does not accurately reflect the economic significance of its constituent companies. Larger companies often have greater revenue, profit, and market influence, which is not reflected when all companies are given the same weight.⁵
• Increased Volatility: Because equally weighted indexes give more weight to smaller companies, which tend to be more volatile than large-cap companies, these indexes can exhibit higher overall volatility than market-cap-weighted indexes.³, ⁴
• Scalability Issues: As the size of assets tracking an equally weighted index grows, the impact of transaction costs due to frequent rebalancing, especially in less liquid smaller companies, can become more pronounced and negatively affect net performance.²

Equally Weighted Index vs. Market-Capitalization-Weighted Index

The primary distinction between an equally weighted index and a market-capitalization-weighted index lies in how the constituent securities are weighted.

The confusion between the two often arises because they may track the same underlying universe of securities (e.g., the S&P 500). However, the differing weighting methodologies lead to distinct performance characteristics, risk profiles, and implicit factor exposures.

FAQs

What is the main advantage of an equally weighted index?

The main advantage of an equally weighted index is its reduced concentration risk, as it prevents a few large companies from overly influencing the index's performance. It also offers a more diversified exposure across all constituents.

Why do equally weighted indexes often have higher turnover?

Equally weighted indexes have higher turnover because they require regular rebalancing. When a stock's price changes, its weight in the index deviates from the equal proportion. To restore the equal weight, parts of outperforming stocks must be sold, and underperforming stocks must be bought, leading to more frequent trading. This can impact portfolio returns due to increased costs.

Can I invest directly in an equally weighted index?

No, you cannot invest directly in an index. However, you can invest in financial products such as exchange-traded funds (ETFs) or mutual funds that are designed to track the performance of specific equally weighted indexes.

Do equally weighted indexes always outperform market-cap-weighted indexes?

No. While equally weighted indexes have periods of outperformance, particularly when smaller companies or value stocks are in favor, they do not always outperform market-cap-weighted indexes. Their performance depends on market cycles and which factors are currently driving returns. The Invesco S&P 500 Equal Weight ETF, for example, has shown periods of outperformance against the S&P 500 Index since its inception.¹ However, it's important to remember that past performance does not guarantee future results. Investors should consider their own investment objectives and risk tolerance before choosing an index strategy.