Why use an “Equal Weight” index fund or ETF?

In this article we contrast traditional market-cap weighted index with an Equal Weighted index. 

What is a market-cap weighted index: how do traditional indices work?

​A traditional market-capitalisation weighted index (such as the FTSE 100 in the UK or S&P 500 in the US) weights companies by their market capitalisation (the value of the business being the share price for a share multiplied by the number of shares). The FTSE 100 therefore represents the largest 100 companies by market capitalisation.  The company’s weight in the index is (in broad terms) its market capitalisation as a proportion of the combined market capitalisation of all companies in the index.  This creates an inherent bias to large caps.

What drives a company’s market capitalisation and hence weight in a traditional market-cap index?

​The bigger a company’s earnings and/or the higher it’s earnings multiple, the bigger it’s “market capitalisation” (or “market value”), and hence the higher its % weight in the index.  There are more nuanced “tweaks” (such as freefloat adjustments), and any such index rules are captured in the index methodology document.

What are the advantages of a traditional market-cap index?

The advantages of a traditional market-cap index are:

1. They focus on the largest (hence most successful) companies
2. They are the most familiar and most ubiquitous type of index
3. Their methodology is relatively straightforward

The disadvantages of a traditional market-cap index are:

1. Concentration risk the index can be dominated by its largest holdings
   
2. Skew: the performance of the index is skewed by its largest holdings
   
3. Unintended biases: the index can be dominated by certain regions, sectors, or factor styles, creating unintended bias to that region, sector or factor style

What is an Equal Weight Index?

An Equal Weight index is an even simpler methodology, which creates interesting effects.
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For an equal weight index of 100 companies has a weighting of 1/100th (1%) in each company.  For this reason this index construction is also known as a 1/N index or a “deconcentration” index.

The performance of the index is not skewed by the largest market capitalisation companies.  The performance is driven by the performance of each individual company on an equally weighted basis.  This creates an inherent bias to small caps.

What are the advantages of an equal weighted index?

The advantages of an equal weighted index are:

1. The methodology is very simple
   
2. Each company’s share price has impact on overall index performance
   
3. It provides a differentiated approach that complements a market-cap weighted index

The disadvantages of an equal weighted index are:

1. It is less familiar
2. Performance is less publicly reported
3. There is more niche interest

Bottom Line

There is no right or wrong about indices.  Different index methodologies have different inherent characteristics.  Understanding those characteristics and potential resulting applications is key for asset allocators.
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Choosing between a market-cap weighted index or an equal weighted index is therefore contingent on what characteristics you want to emphasis or want to suppress.

Find out more

We first published research on this back in 2020, and then did a CISI-endorsed CPD webinar with S&P Dow Jones Indices back in June 2021. 

Read more of our Equity related research
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Read more of our Index Investing research