What is the Equal Weighted Index?

Explanation

The majority of the stock indexesStock IndexesThe stock index, which is also known as the stock market index, is a tool used to determine the performance of shares/securities in the market and to calculate the return on the stock of their investment investors use it to have knowledge about the performance of investments and access the total value they possess.read more are either market capitalizationMarket CapitalizationMarket capitalization is the market value of a company’s outstanding shares. It is computed as the product of the total number of outstanding shares and the price of each share.read more index or price-weighted index Price-weighted IndexPrice-Weighted Index is the stock index where the member companies are allocated based on the proportion of the price per share of the respective member companies and help keep track of the economy’s overall health with its current condition. PWI Formula = Sum of Members Stock Price/Number of members.read more. The market capitalization index gives more importance to stocks with high market capitalization. On the other hand, as the name suggests, the price-weighted index provides significance 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 considers investment equally in each stock making up the index. Thus, if the price of a stock in an index fundIndex FundIndex Funds are passive funds that pool investments into selected securities.read more goes down, this fund will buy more shares. 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 market capitalization, firm size, or share price.They are more diversified.Due to buying and selling, the trading cost 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?

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It is calculated by assigning the same weight to each stock in the index. For example, suppose there are only three stocks in the market. It will give each a weightage of 33.3% (100/3). The formula for calculation of this index in simple terms would be as follows: –

Value of Equal Weighted Index = (Price of Stock A * Weight Assigned) + (Price of Stock B * Weight Assigned) + (P of Stock C * Weight Assigned)

To calculate the new index using the old equal-weighted index, we will have to calculate the arithmetic meanArithmetic MeanArithmetic mean denotes the average of all the observations of a data series. It is the aggregate of all the values in a data set divided by the total count of the observations.read more of the return on each stock in the fund or the percentage change in the index value. The formula for the new weighted index from the old index is as follows: –

New Index = Old Equal Weighted Index + (1- % Change in Index)

Example

Let’s take an example.

Let us assume there are four stocks in the equal-weighted index- Stock A, Stock B, Stock C, and Stock D and the prices of each stock are as follows: –

Solution:

The calculation of the Equal Weighted Index will be –

Equal Weighted Index and Small Business

They give importance to each stock equally. It favors smaller companies since they are weighted equally to large firms irrespective of market capitalization or share price. They do not get such an advantage in the market-capitalization-weighted index, where the weight of each stock is given according to its 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 than small or mid-cap stocksMid-cap StocksMid-Cap stocks are the stocks of the companies having medium market capitalization. Their capital lies between that of large and small cap companies and valuation of the entire share holdings of these companies range between $2 billion to $8 billion.read more.

On the contrary, they give equal value to each stock irrespective of the company’s market capitalization size. So, to balance the fund, it will have to buy more securities for stocks whose price has decreased and sell the securities for those whose prices have increased.

Advantages

  • The long-term performance of this index is better than 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 balanced, there is a high transactional cost or portfolio turnover rate.The index is more volatile 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, it may have tax implications.

This article is a guide to the Equal-Weighted Index. We discussed equally weighted index calculation, equal-weighted index formula, and practical examples. You may learn more about investment banking from the following articles: –

  • Volatility IndexTotal Return IndexIndex OptionsFTSE Indices