What is the Equal Weighted Index?
The equal-weighted index is one of the stock indices that assign or give equal value to all the stocks in the index and therefore, the total value of the index is determined by the value of each stock as if all of them carry equal importance or value in the calculation of the index. No importance is given to the market capitalization of the stocks and all stocks are assigned equal weightage.
Explanation
The majority of the stock indexes are either market capitalization index or price-weighted index. Market capitalization index gives more importance to the stocks with high market capitalization, and the price-weighted index, as the name suggests, gives importance to the stocks according to their prices, i.e., price is the only consideration in calculating the price-weighted index.
The equal-weight index assigns the same value to all the stocks and therefore considers investment equally in each stock making up the index. Thus, if the price of a stock in an index fund goes down, this fund will buy more shares, and if the price goes up, it will sell shares to balance the fund equally in the index. Due to more buying and selling activity, trading cost remains high in the equal-weighted index fund.
Features
- They assign the same value to each stock making up the index irrespective of their market capitalization, size of the firm, or price of the share.
- They are more diversified.
- Due to a lot of buying and selling, the trading cost in the case of funds based on an equal-weighted index remains high.
- Funds based on this index indicate a less risky option.
How to Calculate the Equal Weighted Index?
It is calculated by assigning the same weight to each stock in the index. Suppose if there are only three stocks in the market, each will be assigned a weightage of 33.3% (100/3). The formula for calculation of this index in simple terms would be as follows:
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To calculate the new index using the old equal-weighted index, we will have to calculate the arithmetic mean of the return on each stock in the fund or percentage change in the index value. The formula for the new weighted index from the old index is as follows:
Example
Let’s take an example.
Let us assume there are four stocks in the equal-weighted index, Stock A, Stock B, Stock C, Stock D. Prices of each stock are as follows:
Solution:
Calculation of Equal Weighted Index will be –
Equal Weighted Index and Small Business
They give importance to each stock equally. This plays a favorable role in respect of smaller companies since they are weighted equally as large firms irrespective of their market capitalization or share price. They do not get this kind of advantage in the market-capitalization-weighted index, where weight to each stock is given according to their market capitalization in the economy.
Equal Weighted Index vs. Capitalization Weighted Index
Market capitalization gives value to top stocks according to their market capitalization. Therefore, the largest companies with huge market capitalization will get more value in comparison to small or mid-cap stocks.
On the contrary, they give equal value to each stock irrespective of the size of the market capitalization of the company. To balance the fund, it will have to buy more securities for stocks whose price has gone down and sell the securities of the stocks whose prices have gone up.
Advantages
- The long-term performance of this index is better in comparison to other indices.
- This index is not concentrated only on the largest company stocks. Thus it is more diversified.
- Since the index is diversified, it carries a lesser risk.
- This index does not give over importance to overpriced stocks.
Disadvantages
- Due to a large amount of buying and selling to keep the index fund in balance, there is a high transactional cost or portfolio turnover rate.
- The index is more volatile in nature in the event of a recession.
- The underperforming companies are given the same weight in the index.
- Due to the high transaction cost and portfolio turnover rate, there can be tax implications.
Recommended Articles
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