Unweighted Index  and Examples

Unweighted Index and Examples

An unweighted index is comprised of securities with equal weight within the index. The weighted index shows performance typically by market capitalization, while the unweighted index reflects unweighted performance across the index's components. An index fund or ETF structured on an unweighted index, on the other hand, sticks to equal allocations among the components of an index. It may be a better index for an investor who isn't investing in the most heavily weighted stocks of a weighted index, or is more interested in whether most stocks are moving higher or lower. It is a weighted index based on market capitalization, although the index caps how much of a weight any individual stock can have.

An unweighted index gives equal allocation to all securities within the index.

What is an Unweighted Index?

An unweighted index is comprised of securities with equal weight within the index. An equivalent dollar amount is invested in each of the index components. For an unweighted stock index, one stock's performance will not have a dramatic effect on the performance of the index as a whole.

This differs from weighted indexes, where some stocks are given more percentage weight than others, usually based on their market capitalizations.

An unweighted index gives equal allocation to all securities within the index.
A weighted index gives more weight to certain securities, typically based on market capitalization.
One index type isn't necessarily better than another, they are just showing data in different ways.

Understanding the Unweighted Index

Unweighted indexes are rare, as most indexes are based on market capitalizations, whereby companies with larger market caps are accorded higher index weights than companies with lower market caps.

The most prominent of the unweighted stock indexes is the S&P 500 Equal Weight Index (EWI), which is the unweighted version of the widely-used S&P 500 Index. The S&P 500 EWI includes the same constituents as the capitalization-weighted S&P 500 Index, but each of the 500 companies is allocated a fixed percentage weight of 0.2%.

Implications for Index Funds and ETFs

Passive fund managers construct index funds or exchange-traded fund (ETF) based on leading indexes such as the S&P 500 Index, which is a weighted index. Most choose to mimic their investment vehicles on market capitalization-weighted indexes, which means they must buy more of the stocks that are rising in value to match the index, or sell more of the stocks that are declining in value. This can create a circular situation of momentum where an increase in a stock's value leads to more buying of the stock, which will add to the upward pressure on the price. The reverse is also true on the downside.

An index fund or ETF structured on an unweighted index, on the other hand, sticks to equal allocations among the components of an index. In the case of the S&P 500 Equal Weight Index, the fund manager would periodically rebalance investment amounts so that each is 0.2% of the total.

Is Unweighted or Weighted Better?

One type of index isn't necessarily better than another, they are just showing different things. The weighted index shows performance typically by market capitalization, while the unweighted index reflects unweighted performance across the index's components.

One of the pitfalls of a weighted index is that returns will be based largely on the most heavily weighted components, and the smaller component returns may be hidden or have little effect. This could mean that most of the stocks in the S&P 500, for example, are actually declining even though the index is rising because the stocks with the most weight are rising while most of the stocks with little weight are falling.

The flip side of this argument is that smaller companies come and go, and therefore they shouldn't be given as much weight as the large companies with a much larger shareholder base.

An unweighted or equal weight index reflects how a whole pool of stocks is doing. It may be a better index for an investor who isn't investing in the most heavily weighted stocks of a weighted index, or is more interested in whether most stocks are moving higher or lower. The unweighted index does a better job of showing this than a weighted index.

In terms of performance, sometimes an unweighted index outperforms the weighted index, and other times the reverse is true. When deciding which is a better index to track or mimic, look at the performance and volatility of both to assess which is the better option.

Real World Example of Weighted and Unweighted

The Nasdaq 100 Index is one hundred of the largest companies listed on the Nasdaq exchange. It is a weighted index based on market capitalization, although the index caps how much of a weight any individual stock can have.

The Nasdaq 100 Equal Weight Index has an equal weight of 1% assigned to each of the 100 components.

Over time, the weightings can have dramatic effects on returns. The following chart shows the Nasdaq 100 EWI as candles and the Nasdaq 100 as a pink line.

Between 2006 and 2019, the Nasdaq 100 returned 70% more than its EWI counterpart, showing that the larger-cap stocks tended to bolster returns for the weighted index. This may not always be the case. Depending on the index, sometimes the unweighted version outperforms the weighted version.

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Image by Sabrina Jiang © Investopedia 2021

Along the bottom of the chart is a correlation coefficient, showing that most of the time the two indexes are highly correlated, near a value of one. But on occasion, the two indexes diverge or may not move in the same direction. These are periods where how the index is weighted affects its performance relative to the other.

Related terms:

Candlestick

A candlestick is a type of price chart that displays the high, low, open, and closing prices of a security for a specific period and originated from Japan. read more

Constituent

A constituent is a single stock or company that is part of a larger index such as the S&P 500 or Dow Jones Industrial Average.  read more

Correlation Coefficient

The correlation coefficient is a statistical measure that calculates the strength of the relationship between the relative movements of two variables. read more

Divergence and Uses

Divergence is when the price of an asset and a technical indicator move in opposite directions. Divergence is a warning sign that the price trend is weakening, and in some case may result in price reversals. read more

Equal Weight

Equal weight is a proportional measure that gives the same importance to each stock in a portfolio or index fund, regardless of a company's size. read more

Exchange Traded Fund (ETF) and Overview

An exchange traded fund (ETF) is a basket of securities that tracks an underlying index. ETFs can contain investments such as stocks and bonds. read more

Index Fund

An index fund is a pooled investment vehicle that passively seeks to replicate the returns of some market indexes. read more

Large Cap (Big Cap)

Large cap (big cap) refers to a company with a market capitalization value of more than $10 billion. read more

Market Capitalization

Market capitalization is the total dollar market value of all of a company's outstanding shares. read more

Momentum

Momentum is the rate of acceleration of a security's price or volume. Momentum generally refers to the speed of movement and is usually defined as a rate. read more