Equally Weighted Index
An equally weighted index weights each stock equally regardless of its market capitalization or economic size (sales, earnings, book value). Due to daily price movements of the stocks within the index, the portfolio must be constantly re-balanced to keep the positions in each stock equal to each other.
Advantages
- The index is highly diversified with all stocks in the universe equally weighted.
- As opposed to market cap weighting, the index does not overweight overpriced stocks and underweight underpriced stocks. Pricing errors are random.
- Easy to construct relatively tax efficient ETFs and mutual funds.
- Usually adds 1 – 2 percent in annual return over long periods after expenses vs. market cap weighted indexes.
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Disadvantages
- No distinction is made between the relative or absolute valuation of stocks within the universe.
- Difficult to keep the stocks in the index equally weighted due to constant price fluctuations.
- Difficult for this type of index to manage substantial amounts of money due to the need to invest equal amounts in both the largest and smallest stocks.
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How to Calculate
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ASSUME THE STOCK MARKET HAS ONLY THREE COMPANIES:
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| |
Market
Capitalization |
|
Last Year's
Earnings |
| Company A = |
$6 billion |
|
$100 million |
| Company B = |
$3 billion |
|
$300 million |
| Company C = |
$1 billion |
|
$200 million |
Total Market Cap
of All Companies |
$10 billion |
Total Earnings
of All Companies |
$600 million |
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EQUALLY WEIGHTED INDEX
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Company A |
= |
33% weight in index |
|
| |
Company B |
= |
33% weight in index |
|
| |
Company C |
= |
33% weight in index |
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| The equally weighted index weights all companies equally, regardless of size.
Here, there are three companies in the stock universe, and therefore each gets a
one- third weight in the index. |
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Examples
*Certain ETFs may have tax advantages over mutual funds. If managed well, most capital gain tax obligations are only recognized upon the sale of the ETF. Please note that ETFs with smaller market capitalizations are sometimes terminated by the sponsor with unexpected tax consequences. Therefore, it may be prudent to invest in ETFs with larger market capitalizations.
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