What is an “Equally Weighted Index”?
An Equally Weighted Index (EWI) is a type of stock market index in which the stocks of all the constituent companies are assigned an equal value. Therefore, the value of an EWI is determined by the value of each stock in the index, and all stocks are accorded equal importance. Consequently, in an EWI, all companies, regardless of their size (i.e. however big or small they are) and stock price, have the same level of influence on the index. The calculation for each weighting is simply 1/N, with N being the number of companies within the index. An example of an EWI is the S&P 500 Equal Weighted Index, which is a derivative of the S&P 500.
Key Learning Points
- In an EWI, every stock is assigned equal weighting and therefore each company has equal importance in determining the index value
- An EWI is considered more diversified than a Market Value Weighted Index (MVWI)
- EWI’s are more vulnerable to unexpected falls in value during a bear market
Equally Weighted Indices (EWI) – Formula, Advantages and Disadvantages
In an EWI, the stock of each constituent company is assigned the same weight. Therefore, if for example, there are four stocks, each one will be assigned a weight of 25% i.e. (100/4). The stock price of each constituent company is multiplied by their respective weights and then added together to arrive at the EWI value.
EWI Value = (Stock Price 1*Assigned Weight) + (Stock Price 2*Assigned Weight) + (Stock Price 3*Assigned Weight) + (Stock Price N*Assigned Weight)
Essentially, what it reflects is that the performance of the stock of each constituent company in the index carries equal importance in determining the EWI value. Further, such an index is based on value.
An EWI differs substantially from a Market Value Weighted Index (MVWI), which is the most common type of stock market index today (for example, the S&P 500 and FTSE 100).
In an EWI, smaller-cap companies are accorded the same importance as large-cap stocks i.e. there is no market capitalization bias, as all companies of any size are accorded equal weights. Whereas, in a MVWI, the index is heavily biased in favour of the largest companies in terms of market capitalization. Therefore, in effect, an EWI favours smaller-cap companies, as they are given the same importance as large-cap companies.
There are some advantages of EWI’s. First, they are perceived to carry less risk, when compared to MVWIs as they are considered more diversified. Secondly, equally-weighted funds are very useful when using a ‘value investing’ strategy (which involves choosing stocks that appear to be trading at less than their intrinsic or book value) partly to the bottom-up stock-picking strategy.
Next, in terms of long-term performance, the EWI tends to perform better when compared to other types of indices. Finally, it is worth noting that an EWI does not give undue importance to overpriced stocks.
It is difficult to conclude which is better – an EWI or a MVWI. This is because in some instances, for example in the US, an EWI version of the S&P 500 consistently outperformed the S&P 500 for several years, whereas, an EWI of the NASDAQ-100 underperformed relative to the MVWI NASDAQ-100.
For investors who have to decide whether to invest in a fund that uses an EWI, or invest in a fund that uses MVWI, the decision is predicated on the type of index (EWI or MVWI) they believe is most expected to give the highest ROI (return on investment).
In terms of potential downside, EWI’s tend to be more vulnerable to unexpected and volatile falls in stock price value during a bear market. Whereas, MVWI, are likely to be more stable through a bear market phase, as they are substantially invested in large-cap stocks. In an EWI, underperforming companies are accorded the same weightage in the index. Moreover, in an EWI, there can be tax implications due to high transaction costs and portfolio turnover rates.
Equally Weighted Indices (EWI), Example
Here is an example, where the EWI has been calculated. Assume there are four stocks in an EWI. Their stock prices along with their respective weights are stated. A weightage of 25% is assigned to each stock (25/100).
Next, the stock price of stocks AB, AC, AD, and AE are multiplied by their respective weights to arrive at the EWI value of 94.25.