What is an Unweighted Index?
An unweighted index consists of securities where each one is equally weighted. In simpler terms, an equivalent amount of money is invested in each component of the index. For a stock index that is unweighted, no single stock’s performance has an outsized impact on the overall index’s performance.
This approach contrasts with weighted indexes where certain stocks are given more significance, typically based on their market capitalizations.
Key Takeaways
- An unweighted index equally allocates all securities within its scope.
- Weighted indexes accord more weight to certain securities, often based on their market caps.
- One index type is not necessarily superior; both provide unique insights.
Unveiling the Power of Unweighted Indexes
Unweighted indexes are rare, as most indices are based on market capitalizations. A prime example of an unweighted index is the S&P 500 Equal Weight Index (EWI). This index includes the same stocks as the market capitalization-weighted S&P 500 Index. However, in the EWI, each of the 500 companies is allocated a fixed weight percentage, which is 0.2%.
Implications for Index Funds and ETFs
Passive fund managers frequently construct index funds or exchange-traded funds (ETFs) based on widely-followed markets like the S&P 500 Index, which is weighted. To maintain parity with the index, these managers need to adjust their portfolios, buying rising stocks and selling declining stocks. This periodically intensifies momentum where price increases foment more purchases, and vice versa for price decreases.
However, for an ETF mirroring an unweighted index like the S&P 500 EWI, managers maintain equal allocations among all index components. This leads to periodic rebalancing to ensure each component is accurately represented.
Unweighted vs. Weighted: Which is Better?
Determining whether an unweighted or weighted index is better depends on what an investor seeks to understand. Weighted indexes reflect performance mainly by market capitalization, whereas unweighted indexes display the performance across the entirety of its components more equitably.
In weighted indexes, the returns largely derive from heavily weighted components. Smaller components may go unnoticed or have minimal effect. For example, the S&P 500 may rise even as several smaller stocks decline, masked by gains in larger stocks.
Conversely, because smaller companies can be more volatile, assigning them the same weight as larger, stable firms in an index might not always be ideal.
Unweighted indexes offer investor insights into the performance across all stocks, making them preferable for those not focused on heavily-weighted stocks or those wanting a broader market performance gauge. Occasionally, unweighted indexes outperform weighted ones and vice versa depending on market conditions.
Real-World Illustrations of Index Weighting
Take the Nasdaq 100 Index, representing the largest companies listed on the Nasdaq exchange. This index is capital-weighted but has caps on individual stock weights. Comparatively, the Nasdaq 100 Equal Weight Index assigns each stock a 1% weight.
The weight’s impact over time is significant. Between 2006 and 2019, the Nasdaq 100 outperformed its equal-weight version by 70%, indicating that larger-cap stocks prompted better returns.
Beneath the two index charts sits the correlation coefficient, highlighting that although both indexes are generally correlated, they occasionally diverge. These divergences reflect how index weighting affects relative performance.
Related Terms: market capitalization, index funds, exchange-traded funds, stock index, momentum, shareholder, volatility.
References
- S&P Dow Jones Indices. “S&P 500 Equal Weight Index”.
- S&P Dow Jones Indices. “S&P U.S. Indices Methodology”, Page 10.
- Nasdaq. “Nasdaq-100 Index”.
- Nasdaq Group. “NASDAQ-100 Equal Weighted (NDXE)”.
