Equal-Weighted Index

What is an Equal-Weighted Index?

A stock market index comprised of publicly traded companies, in which all constituents are allocated a fixed equal weighting regardless of their share price or market capitalization is called equal-weighted index. Such indices include the same stocks as their respective market-cap-weighted indices, but the equal weighting ensures that all companies have the same influence over the performance of the index. Therefore, the approach provides larger exposure to stocks with mid and smaller market capitalization, which could potentially offer higher returns but may also carry higher volatility. Equal weighted indices also require more frequent rebalancing (the process of changing the weights of individual constituents to adhere closely to its objective), as the weight of each issuer will drift based on the performance of each security. This higher turnover would result in higher transaction costs.

Equal-Weighted Index vs. Capitalization-Weighted Index

The most popular indices that both professional and individual investors use are market cap weighted. This means that the weighting that constituents receive is based on their market capitalization and therefore larger companies get larger weight in the index. For example, the S&P 500 Index (which tracks the performance of the 500 largest listed companies in the US), provides greater weighting to the companies with the highest market capitalization. As of October 2024, Apple had the largest weight in the index with 7.1% followed by Nvidia with 6.7% and Microsoft with 6.2% respectively. In total, the top 10 constituents were accounting for 34.9% of the index is quite high and the performance of these ten stocks will significantly impact the performance of the entire index).

In contrast, the top 10 constituents in the S&P 500 Equal Weight Index (an index where each of the companies that currently feature in the S&P 500 index are given a fixed equal weight) accounted for 2.6% of the index. As a result, the performance drivers for the two indices will differ significantly.

Value and Momentum as the Difference Makers in Indexes

Investors often argue that the performance of traditional market cap indices is largely driven by momentum (i.e. having large exposure to stocks that outperform and avoid those that underperform). This means that the weakest stocks in relative terms are given a lower weight compared to the current top-performing stocks at each rebalancing period. On the other hand, an equally weighted index would trim exposure to the best performing stocks and add more weight to those that underperform to restore its balance. This would naturally lead equal weighted indices to have a higher exposure to value (i.e. stocks that are temporarily underappreciated by the market due to a particular reason, for example missing an earnings target) as shown in the chart below.

If we look at this from a market perspective, passive funds that are based on market cap weighted indices will allocate additional capital towards well-performing stocks as investors buy them, while a company that is underperforming would receive less capital due to its lower index weighting.

Examples of Equal-Weight Funds

There are various providers that offer funds with equal weight portfolios not just focused on the major markets but also more specialist areas such as sector-specific products (here is a link for the S&P’s full suite of equal-weighted indices). One example is the Invesco S&P 500 Equal Weight Financials ETF that is based on the S&P 500 Equal Weight Financials Index and invests at least 90% of its total assets in financial services companies as classified in by Global Industry Classification Standard (known as “GICS”) financials sector. Below are the fund’s top ten holdings and industry allocations.

As we can see from the data, the weightings of each issuer are not exactly equal. This is due to the performance contribution that each company has in the index and these drifts from the original allocation are fixed with the rebalancing of the index (and the fund respectively). In this case, this is taking place quarterly.

The concept and benefits of equal weighting is not only recognized in passive fund management, but some active managers apply it in their approach. For example, Guinness Global Investors construct concentrated, typically equally-weighted portfolios of 35 stocks, aiming to reduce stock-specific risk. Below are the top 10 holdings of their Guinness Global Equity Income fund, which aims to deliver a combination of income and long-term capital growth.

Performance of Equal-Weighted Indices

Introduced over twenty years ago as an alternative to the traditional capitalization-weighted approach for US blue-chip equities, the S&P 500 Equal Weight Index has demonstrated strong long-term performance both against the main index (the S&P 500) and its variations based on either investment style (such as value or growth) or size (mid or small). This is attributed to the ability to avoid market concentration and disciplined regular rebalancing.

However, it should be noted that equal weighting also brings a higher risk as measured by the standard deviation of the index.

Despite that, equal-weighted indices have held better during stock market declines. The below chart shows that their average drawdown was better compared to that of the market cap-weighted indices over the long term.

One essential feature of the equal weighted indices is that they may work better in different market conditions and should the style and/or sector leadership change, so would the performance drivers too. For example, in the current environment market cap indices are dominated by mega cap growth stocks and transitioning to equal weighted indices would mean placing a bet on more value-oriented stocks. This is evidenced on the chat below.

Advantages of Equal-Weighted Index Funds

Among the main advantages for equal weighted indices are:

• Diversification – equal-weighted indices remove the market cap bias and ensure that companies with mid and smaller capitalization have the same influence.
• Higher potential returns – providing greater exposure to smaller companies, which in theory should offer higher growth opportunities relative to their larger peers.
• Lower concentration – equal weighting prevents the dominance of the mega cap companies that occupy the top positions in market cap indices.

Disadvantages of Equal-Weighted Index Funds

On the other hand, equal-weighted indices also bear some disadvantages such as:

• Higher risk – allowing small and mid-caps to have the same influence on performance as the more well-established large-cap stocks result in higher overall volatility for the index.
• Omission of market trends – equal weighting an index may limit the exposure to stocks and sectors favored by the market.
• Higher costs – the process of regularly rebalancing all index constituents leads to higher turnover and therefore higher transaction costs.

Conclusion

Overall, equal-weighted indices were developed as an alternative to the market capitalisation-weighted indices and aimed at removing the market cap bias and offering a more diversified exposure both at a stock and region/sector level. Although they tend to be riskier given their higher allocation to mid and small caps, long-term performance has been strong and they outperformed market cap indices. When considering an equal-weighted product, investors should also be mindful of the cost implications of the regular rebalancing, which is required to maintain the index in line with its objectives.

Additional Resources

Portfolio Performance