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In our last portion to our 3-part series on How Do We Calculate a Stock Index, we find out how to calculate an equal -weighted index.
As the name implies for the equal-weighted index, each stock within the index represents an equal weighting. This assumes that the same amount of money is invested in the shares of each index component An equal-weighted index must be re-balanced equally in order to reestablish the equal weighting. This is because each stock absolute returns will cause the stock weights to move away from the equal weighting proportions.
In the table below, each of the 5 stocks are given equal representation of the index with the base value at 20 for each stock (i.e. 20 x 5 = 100). The value of each component is multiplied by 1 + the return over the year. For example, Stock A’s 2014 return is 20 X (1 + 25%) = 25. The performance of the index shown below is thus 11%.
The weights of each stock would be re-balance to 20 again to reinstate the equal proportion.
An Equal-Weighted methodology helps to reduce exposure given to large-capitalization companies if a market-capitalization weight is used while simultaneously creating a small-company bias as it put these small-capitalization companies on equal proportion with their large-cap counterparts. This will thus include several small companies which tend to be more volatile in price movement as compared to large ones. In order to maintain an equal weighting, the index must be re-balanced periodically and the frequent re-balancing or high turnover can lead to high transaction costs for a portfolio constructed to track the index.
An example of a Equal-Weighted Index is the Value Line Arithmetic Composite Index which represents approximately 1,700 US stocks covered in the Value Line Investment Survey.
Value in Action
The Equal-Weighted Index is one of the 4 different weighting schemes. Although it might not be as popular as the traditional Value-Weighted/Float-Weighted Indices, the equal-weighted index does serve its own merits of reducing large biases to “blue-chip” companies.
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