When implementing an index investing approach, it’s important to understand what an equally weighted index is.
Index investing is a passive investment strategy in which the primary goal is to match the returns of a particular stock index. This is usually achieved through investing in index mutual funds and exchange-traded funds (ETFs).
Equal-weight investing is a smart beta strategy that may appeal to certain types of investors more than others. This article will delve deep into equal-weight investing, including:
• What Is an Equal Weighted Index?
• How to Calculate Equal Weighted Index
• Advantages of Using Equally Weighted Index
• Disadvantages of Using Equally Weighted Index
What Is an Equal Weighted Index?
An equal-weighted index is a stock market index that gives equal value to all the stocks that are included in it. In other words, each stock in the index has the same importance when determining the index’s value, regardless of whether the company is large or small, or how much shares are trading for.
A stock market index tracks the performance of a specific grouping or basket of stocks or a particular sector of the market. For example, the S&P 500 Composite Stock Price Index tracks the movements of 500 companies that are recognized as leaders within their respective industries.
Stock market indices are often price-weighted or capitalization-weighted. In a price-weighted index, the stocks that have the highest share price carry the most weight. In a capitalization-weighted index, the stocks with the highest market capitalization carry the most weight. Market capitalization represents the value of a company as measured by multiplying the current share price by the total number of outstanding shares.
An equally weighted index essentially puts all of the stocks included in the index on a level playing field when determining the value of the index. With a price-weighted or capitalization-weighted index, on the other hand, higher-priced stocks and larger companies tend to dominate the index’s makeup and dictate its performance.
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 Using Equally Weighted Index
An index investing strategy might be preferable if you lean toward more conservative investments or you simply want exposure to a broad market index without concentrating on a handful of stocks. That’s something you’re less likely to get with mutual funds or ETFs that follow a price-weighted or capitalization-weighted index.
Here are some of the reasons to consider an equal-weighted index approach:
• It will increase diversification in your portfolio while potentially minimizing exposure to risk.
• It’s relatively easy to construct an equally weighted portfolio using index mutual funds and ETFs.
• It may appeal to value investors, since there’s less room for overpriced stocks to be overweighted and undervalued stocks to be underweighted.
• Equal-weighted indices may potentially generate better or more incremental returns over time compared to price-weighted or capitalization-weighted indices.
Cap-weighted indices and the funds that track them can be risky since performance is ultimately determined by just a handful of stocks. As long as those top stocks do well, then any funds or ETFs that track the index may follow suit. But equal-weighted index funds could offer more consistent returns over time.
Of course, it’s important to remember that where the stock market is concerned, nothing is guaranteed, and there’s always a risk that equal-weighted index funds may underperform.
Disadvantages of Using Equally Weighted Index
While there are some pros to using an equal weighted approach, it may not always be the best choice depending on your investment goals. In terms of potential drawbacks, there are two big considerations to keep in mind:
• Equal-weighted index funds or ETFs that have a higher turnover rate may carry higher expenses for investors
• These funds may also be more susceptible to volatility in bear market environments
There may be a constant buying and selling of assets that goes on behind the scenes to keep an equal-weighted mutual fund or ETF in balance. Higher turnover ratios, i.e. how often assets in the fund are swapped in and out, can lead to higher expense ratios if a fund requires more active management. The expense ratio is the price you pay to own a mutual fund or ETF annually, expressed as a percentage of the fund’s assets. The higher the expense ratio, the more of your returns you hand back each year to cover the cost of owning a particular fund.
Equal-weighted index funds can also be problematic in bear market environments, which are characterized by an overall 20% decline in stock prices. During a recession, cap-weighted funds may outperform equal-weighted funds if the fund is being carried by a few stable, larger companies.
In an equal-weight index fund, each stock counts equally toward the index’s value, regardless of whether the company is large or small, or how much shares are currently trading for. There are advantages to investing in an equal-weight index fund over a capitalization-weighted index or price-weighted index, for example equal-weighted indices may generate better or more consistent returns. Investing in an equal-weight index may be appealing to investors who prefer a value investing strategy or who want to diversify their portfolio to minimize risk.
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