In an equal-weighted index, a specified amount of money is invested in the stock of every company included within the index.This approach contrasts with market-capitalization-weighted indexes, where the weight of each company is proportional to its market value. In an equal-weighted index, the performance of each company's stock carries equal importance in determining the overall value of the index.
What are equal weight index funds?
Equal weight index funds distribute investments evenly across all securities in a specific index, rather than weighting them by market capitalisation like traditional funds do. Unlike market cap-weighted funds that favour larger companies, each index company receives an equal allocation of funds in an equal-weight index fund. This approach creates a more diversified and balanced portfolio, as smaller companies have an equal influence on the index as larger ones. These funds mitigate concentration risk while providing exposure to a broad range of companies across various sectors and industries.
Available through mutual funds and ETFs, equal-weight index funds are typically more cost-effective than actively managed funds, offering investors an affordable means to diversify their investment portfolios.
Understanding equal weight index funds
- Equal weight index funds track an index where each security receives the same weighting, regardless of its size or market capitalisation.
- Unlike market capitalisation-weighted index funds, which favour larger companies, equal-weight index funds offer diversified exposure to stocks across various industries and sectors.
- This indexing method helps mitigate the risk of concentration in any single company or industry, providing investors with a balanced portfolio.
- Equal-weight index funds ensure that smaller companies have an equal impact on the portfolio as larger ones, offering a more balanced exposure to the overall market.
- These funds typically have lower fees and expenses compared to actively managed funds, potentially leading to better returns over time.
- However, it is important to note that investing in equal-weight index funds does not guarantee higher returns, and suitability depends on an investor's objectives and risk tolerance.
- Before investing, investors should carefully assess their investment goals and understand the underlying index methodology.
Formula of Equal Weight Index Funds
The formula used to calculate the value of this index is as follows:
Equal Weight Index = Stock A price × assigned weight) + (Stock B price × assigned weight) + (Stock C price × assigned weight) + and so on.
Momentum vs value
Momentum and value are two distinct investment strategies used when selecting stocks. Value investing involves identifying stocks that are undervalued based on their intrinsic worth. Investors employing this strategy believe that the market sometimes undervalues certain companies, providing an opportunity to purchase them at a discount. Conversely, momentum investing focuses on stocks that have shown significant price increases over a specific period. Momentum investors anticipate that stocks that have recently performed well will continue to do so.
Both approaches have their advantages and disadvantages and may perform differently depending on market conditions. Value investing emphasises buying low and selling high, while momentum investing capitalises on the theory of "the trend is your friend." Investors must carefully consider their investment goals, risk tolerance, and the fundamental characteristics of the companies they invest in when choosing between these strategies. Understanding the market environment and conducting thorough analysis is essential for successful investing, whether one chooses a momentum or value approach.
Market-cap-weighted vs equal-weight indices
| Equal-weight Indices | Market-cap-weighted Indices | |
| Weighting method | Assigns equal weight to all companies | Gives more weight to companies with higher market capitalisations |
| Impact on index performance | Each company has an equal impact on performance | Larger companies have a greater impact on performance |
| Investor preference | Appeals to investors seeking exposure to smaller businesses or a more diverse portfolio | Preferred by investors seeking exposure to bigger, more established companies |
| Diversification | Offers a more diversified portfolio | May lack diversification due to focus on larger companies |
Equal-weight indices and market-cap-weighted indices represent two distinct methodologies for constructing stock indices. While equal-weight indices distribute the weight evenly among all companies, market-cap-weighted indices give more weight to companies with higher market capitalizations. Investors' preferences often dictate the choice between the two indices, with equal-weight indices appealing to those seeking exposure to smaller businesses or a diversified portfolio, while market-cap-weighted indices are favoured by investors looking for exposure to larger, more established companies.
Advantages of equal-weight index funds
- Diversification: Equal-weight index funds embrace true diversification by evenly spreading risk across all constituents rather than concentrating it in a few large-cap stocks. This helps avoid vulnerability during sectorial rotations and corrections.
- Value investing: These funds follow a value investing approach, considered a superior market strategy compared to momentum-driven investing.
- Trend independence: No single stock can dictate the trend of the index, providing a more balanced representation of the market.
Disadvantages of Equal-Weight Index Funds
- Increased transaction costs: Higher transaction costs contribute to a higher expense ratio compared to other funds.
- Volatility impact: Volatility affects equal-weight index funds significantly. While blue-chip stocks provide stability in volatile markets, equal-weighting them with others may result in a loss of that stability.
- Anomalies in corporate actions: Anomalies may occur during stock splits and mergers, impacting the effectiveness of equal-weight index funds.
How have Equal Weight Indices performed?
Historically, equal-weight indices have shown strong performance, sometimes even outperforming their market-cap-weighted counterparts. This outperformance is often attributed to the exposure equal-weight indices have to smaller companies, which can offer higher growth potential compared to larger, more established firms. However, during periods when larger companies dominate the market, equal-weight indices may underperform. It’s important for investors to consider their financial objectives and risk tolerance before investing in equal-weight index funds, as past performance is not a guarantee of future results. Additionally, equal-weight funds often involve higher costs and require more frequent rebalancing, which can impact overall returns.
Pros & Cons of Equal Weight Indices
Pros
- Greater diversification: Each stock in the index has an equal impact on the portfolio, reducing concentration risk and potentially improving long-term performance.
- Exposure to smaller companies: These indices offer access to smaller firms, which have higher growth potential compared to established businesses.
- Balanced market representation: By not giving preference to large-cap companies, equal-weight indices may provide a more balanced view of the overall market.
- Lower fees: Equal-weight indices typically have lower fees compared to actively managed funds, making them a more cost-effective investment option.
Cons
- Higher turnover: Compared to market-cap-weighted indices, equal-weight indices experience more turnover, which can lead to increased transaction costs and potential tax implications for investors.
- Greater volatility: Since equal-weight indices often include more exposure to smaller companies, they can be more volatile and sensitive to market fluctuations.
- Underperformance during large-cap dominance: When large corporations drive market gains, equal-weight indices may underperform.
- Frequent rebalancing: These indices require more frequent rebalancing, which could affect overall performance.
Build your Equal Weight Index Fund
Investors looking to create their own equal-weight index fund can do so by purchasing equal amounts of each stock in the index. Alternatively, they can use an online brokerage platform that offers commission-free trading of exchange-traded funds (ETFs). For example, if an investor wants to build an equal-weight index fund based on the S&P 500, they would purchase an equal number of shares from each company in the index. Another option is to invest in an equal-weighted ETF, which provides exposure to a diversified portfolio of companies in an equal-weight manner.
Building an equal-weight index fund can offer investors greater diversification, potentially better long-term performance, and lower fees compared to actively managed funds. However, it’s essential to consider the need for rebalancing and potential transaction costs.
Should you invest in equal weight index funds?
Investing in Equal Weight Index Funds can be suitable for investors seeking diversified exposure to the market and looking to reduce concentration risk in their portfolios. However, investors should carefully consider their investment objectives, risk tolerance, and time horizon before making investment decisions.
Performance of Equal Weight Indices
1. Equal-Weighted Wilshire Large-Cap
The Equal-Weighted Wilshire Large-Cap Index is an index that tracks the performance of large-cap U.S. companies by giving equal exposure to each firm, regardless of their market capitalization. Unlike the market-cap-weighted S&P 500, this index does not favor larger companies. Historically, the Equal-Weighted Wilshire Large-Cap Index has outperformed the traditional S&P 500 due to its greater exposure to smaller companies, which have higher growth potential. However, equal-weighted indices can also experience greater volatility and may underperform during periods when large corporations dominate the market. Investors should consider this volatility when weighing their investment options.
2. Equal-Weighted S&P 500
The Equal-Weighted S&P 500 Index is another index that gives equal weighting to each of the 500 largest U.S. companies, irrespective of their market cap. Historically, this index has outperformed the market-cap-weighted S&P 500. This outperformance is largely due to the equal-weighted approach, which gives smaller companies with greater growth potential more representation in the index. However, just like the Equal-Weighted Wilshire Index, it can also be more volatile, particularly in markets dominated by larger firms. Therefore, before investing in equal-weighted S&P 500 index funds, investors must carefully assess their financial goals and risk tolerance.
3. Equal-Weighted Sector Indices
Equal-weighted sector indices offer exposure to specific industries, such as technology or healthcare, by giving each company in the sector equal representation. This strategy reduces the risk of over-concentration in a few large-cap companies within the industry. An example of this is the Guggenheim S&P 500 Equal Weight Technology ETF, which equally distributes exposure across 69 technology firms included in the S&P 500. While these sector-specific indices have historically outperformed their market-cap-weighted counterparts over the long term, they tend to be more volatile, particularly during periods of market instability. Investors should carefully consider these factors before investing in equal-weighted sector indices.
4. Equal-Weighted MSCI Indices
Equal-weighted MSCI indices track the performance of companies in specific regions or countries, offering equal exposure to all firms, regardless of size. One example is the MSCI World Equal Weighted Index, which includes companies from 23 developed countries. These indices have historically outperformed their market-cap-weighted counterparts due to their greater exposure to smaller companies with strong growth potential. However, similar to other equal-weighted indices, they can be more volatile, especially during periods of market turbulence. Investors should evaluate their investment goals and risk tolerance before considering equal-weighted MSCI indices or any other type of equal-weighted index.
Conclusion
Equal weight index funds offer investors a unique opportunity to gain diversified exposure to the market while minimising concentration risk and capturing different market trends. By understanding how these funds work and their potential benefits, investors can make informed decisions to achieve their investment objectives. It is advised that with any investment, investors should conduct thorough research and consult with financial professionals to determine whether Equal Weight Index Funds align with their investment goals and risk tolerance.
