What Is an Unweighted Index?
An unweighted index gives the same allocation to all securities included in the index. On the other hand, a weighted index gives more importance to specific securities, usually based on their market capitalization. Neither index type is inherently superior to the other, as they simply present data in different ways.
Basics
In an unweighted index, securities are equally weighted, with an equivalent dollar investment in each component. Consequently, a single stock's performance minimizes the impact on the overall index performance. This stands in contrast to weighted indexes, where stocks receive varying percentage weights, typically determined by their market capitalizations.
Exploring Unweighted Index Concepts
Uncommon in practice, unweighted indexes deviate from the norm of market capitalization-based indices, where companies with larger market caps hold greater index influence than those with lower caps. The S&P 500 Equal Weight Index (EWI) stands out as a notable example among unweighted stock indexes. A counterpart to the widely adopted S&P 500 Index, the S&P 500 EWI maintains identical constituents. However, each of the 500 companies is assigned a consistent 0.2% weight, distinguishing it from the capitalization-weighted S&P 500 Index.
Impacts on Index Funds and ETFs
Passive fund managers shape index funds or exchange-traded funds (ETFs) according to influential indexes like the S&P 500, a weighted benchmark. The majority opt for mirroring market capitalization-weighted indexes, necessitating stockholder adjustments based on value fluctuations. This dynamic can foster a feedback loop, where a stock's value surge prompts increased purchases, amplifying upward price pressure. Conversely, the same mechanism operates in a downturn.
Conversely, an index fund or ETF following an unweighted index adheres to uniform allocations across index components. In the instance of the S&P 500 Equal Weight Index, periodic rebalancing ensures each constituent maintains a fixed 0.2% share of the total.
Comparing Unweighted and Weighted Indexes
Determining the superiority of one index over the other is not straightforward; they simply highlight different aspects. The weighted index gauges performance predominantly through market capitalization, while the unweighted index mirrors performance evenly among its components.
A drawback of the weighted index lies in its reliance on heavily weighted components, potentially obscuring or minimizing the impact of smaller components. Consequently, despite the index's overall rise, a substantial portion of stocks in, for instance, the S&P 500, maybe in decline, overshadowed by the ascent of high-weighted stocks. Conversely, proponents argue that smaller companies, with their transient nature, should not wield as much influence as larger companies with broader shareholder bases.
An unweighted or equal-weight index offers a holistic perspective on a pool of stocks. It proves advantageous for investors steering clear of heavily weighted stocks in a conventional index, prioritizing the overall movement of most stocks. In this context, the unweighted index provides a comprehensive picture compared to its weighted counterpart.
In terms of performance, fluctuations occur, and the superiority of an unweighted or weighted index is context-dependent. When evaluating which index to follow or replicate, scrutinize the performance and volatility of both to make an informed decision.
Weighted vs. Unweighted Indexes: Real Examples
Illustrating the concept are the Nasdaq 100 Index and its counterpart, the Nasdaq 100 Equal Weight Index. Comprising a hundred leading companies from the Nasdaq exchange, the Nasdaq 100 operates as a market-capitalization-weighted index, with individual stock weights capped. Conversely, the Nasdaq 100 EWI assigns an equal weight of 1% to each of its 100 components.
Over the 2006-2019 period, the Nasdaq 100 outperformed its EWI counterpart by a significant 70%, showcasing the influence of larger-cap stocks on weighted index returns. However, this trend is not universal, and the performance dynamics may vary between weighted and unweighted versions.
Conclusion
The choice between unweighted and weighted indexes reflects different data representation approaches. Unweighted indexes allocate equally to all securities, while weighted indexes emphasize specific securities based on market capitalization. Neither approach is inherently superior; they present data differently. The decision should be guided by a thorough analysis of their performances and volatilities.