You've almost certainly heard of prominent names like the S&P 500 Index or the Nasdaq 100. Both indexes are often used as benchmarks to measure the overall health of the stock market. Many investors also choose to put their money into index funds or ETFs that track these benchmarks, which offer a simple way to diversify.
But did you know that not all indexes are created equal? The way an index is constructed can significantly impact its performance and risk profile. Two of the most common methods of index construction are market-capitalization weighting and equal weighting. Understanding the difference between these two approaches is key to making informed decisions that align with your investment goals.
What Is a Market-Weight Index?
A market-capitalization weighted index, often called a market-weight index, is the most well-established type of index.1 This approach assigns weightings to the index components based on their market capitalization, which is calculated by multiplying a company’s stock price by its number of shares outstanding. A market-cap weighted index offers a neutral representation of the market itself.
In this type of index, the largest companies in the market have the most significant impact on movements in the index value. The bigger the company, the bigger its slice of the index pie.
How it works: Imagine an index with just three companies:
- Company A: $800 billion market cap
- Company B: $150 billion market cap
- Company C: $50 billion market cap
The total market cap of this simple index is $1 trillion. In a market-weight structure, Company A would make up 80% of the index ($800B / $1T), Company B would be 15%, and Company C would be just 5%. The performance of Company A would dominate the index's returns.
You can see how, in a market-weight index like the S&P 500, megacaps have a much larger impact on the index's movement than smaller companies. If a megacap like Apple* has a great day in the market, it would boost the entire index more significantly than if a smaller company has a similarly happy day. Conversely, a down day for one of the market giants can drag the index down, even when many smaller company stocks are rising.
The benefits of market-weighted indexes
They reflect the market: Many believe this approach offers a true snapshot of the stock market in its current incarnation. The largest, most influential companies have the most significant impact, which reflects their role in the economy.
Lower turnover and cost: Market-weight indexes adjust themselves naturally. As a company's stock price goes up, its market cap increases, as does its weighting in the index. Since the index resets itself, its nature can lead to less frequent rebalancing, which potentially means lower transaction costs for the funds that track them. These savings can often be passed on to investors through lower expense ratios.
Momentum-driven: These indexes ride the wave of hot stocks. As successful companies grow larger, their influence increases, allowing investors to benefit from the continued momentum.
The downside of market-weighted indexes
Concentration risk: One of the greatest drawbacks to this type of index is that it becomes heavily concentrated in the market’s biggest names. If those top-tier stocks falter, they disproportionately harm the index's performance. Near the end of August this year, the top ten stocks constituted 38% of the S&P 500, an all-time high.2
Vulnerability to bubbles: This concentration can make the index susceptible to market bubbles. If a particular sector or a few stocks become overvalued, a market-weight index may become over-exposed to them. When the bubble eventually pops, the index can suffer substantial losses.
What Is An Equal-Weight Index?
An equal-weight index takes a more democratic approach. As the name suggests, every component company is given the same weight in the index, regardless of its size and market capitalization.
In an equal-weight version of the S&P 500, for example, each of the 500 companies would represent 0.2% (1/500) of the index. Consequently, the smallest name in the index will have the same potential impact on performance as the largest company.
How it works: Let’s take the three-company example previously used:
- Company A: $800 billion market cap
- Company B: $150 billion market cap
- Company C: $50 billion market cap
In an equal-weight index, each company would constitute 33.3% of the index. With the weights equal, Company C’s performance would now exercise just as much influence over total index performance as Company A’s results.
To maintain the equal weighting, these indexes must be rebalanced periodically, typically quarterly. To rebalance, the fund manager sells some of the holdings that have performed well (as their weighting would have increased) and buys more of the stocks that have underperformed (as their weighting would have decreased). This approach reinforces a "buy low, sell high" discipline.
The benefits of equal-weight indexes
Greater diversification: With every company given the same weight, this index avoids the concentration risk found in the market-weighted approach. A strategy run off an equal-weighted index doesn’t depend on the performance of a few mega-cap stocks to succeed.
Exposure to smaller companies: This type of index provides greater exposure to smaller and mid-sized companies.3 This weighting can offer the potential for higher returns over the long term.
Systematic rebalancing: Regular rebalancing forces a disciplined investment strategy. It inherently takes profits from winners and reinvests them into underperformers, which can be a powerful tool for capturing value.
The drawbacks of equal-weight indexes
Higher cost: Frequent rebalancing often leads to higher transaction costs. As a result, ETFs and mutual funds that track these indexes typically may have higher expense ratios than their market-weight peers.
Potential for lower returns in momentum markets: During periods in which a few large-cap stocks are driving the market's growth (like the tech boom of recent years), equal-weight indexes may underperform. Because they reduce their positions in outperforming stocks during rebalancing, they can miss out on some of the continued upward momentum.
Increased Volatility: Because they give more weight to smaller, often more volatile stocks, equal-weight indexes can sometimes experience greater price swings than market-weight indexes.
How to Choose the Index to Best Suit Your Needs
How should an investor choose between a market-weight or an equal-weight index fund? The answer depends on your investment philosophy, risk tolerance, and long-term goals.
A market-weight index might be right for you if:
- You’re a passive investor looking for the lowest possible fee structure.
- You want your investment to reflect the overall market.
- You believe that the largest and most successful companies will continue to be market leaders.
An equal-weight index might be a better fit if:
- You’re concerned about the risk of having too much concentration in just a few top stocks.
- You believe that smaller and mid-sized companies have greater growth potential.
- You’re comfortable with slightly higher fees and potential volatility in exchange for greater diversification and a disciplined "buy low, sell high" strategy.
Ultimately, there’s no best answer. Many investors choose to combine both in their portfolios. For example, you might consider allocating the core of your portfolio to a low-cost market-weight index fund and then add a smaller position in an equal-weight fund to gain more exposure to smaller companies and benefit from the rebalancing strategy.
By understanding how these indexes are constructed, you can make choices that align your investments with your long-term financial goals.
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