What is an Equal-Weighted Index?
An equal weighted index is a stock market index which invests an equal amount of money in the stock of each company that makes up the index.
The performance of each company’s stock carries equal importance in determining the total value of the index.
There is no unjustified concentration on few stocks or particular sector.
How to Calculate Equal-Weighted Index
To calculate equal weighted index, you need to know two things:
- Share price of each stock that’s included in the index
- Total number of stocks included in the index
If you’re calculating equal-weighted index value for an index that has five stocks in it, each one would be weighted at 20%, regardless of its stock price. To find 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 share prices fluctuate, the equally weighted index value can 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 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).