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Equally weighting an index reduces concentration

Capitalization weighted indexes, the standard type of equity market benchmark, may show signs of concentration. This means that the behavior of the index as a whole is influenced to a great extent by a small number of large-cap stocks.

Index concentration can be measured using a Lorenz curve. This shows the cumulative weighting (in percent) of the first x percent of index stocks.

A recent Lorenz curve for the FTSE 100 index is shown in the chart below.                                                                                                                                                                                                                                                                                                                                                                      

Source: FTSE, as at 30 June 2014. Royal Dutch Shell A and B are considered to be one FTSE 100 index constituent. Index concentration levels vary over time.

As at the end of June 2014, the largest ten constituents of the index contributed 43.6% of its overall market value. The top 25 stocks contributed over 70% of the index’s value.

One very simple way to address index concentration is to equalize the weights of all the constituents. For the FTSE 100, this means allocating a 1% weighting to each index member.

FTSE calculates a version of the FTSE 100 index in which the weightings of all companies are the same, called the FTSE 100 Equally Weighted index. The recent weighting differences between this index and the cap-weighted FTSE 100 are shown in the chart below.

Source: FTSE, as at 30 June 2014. Royal Dutch Shell A and B are considered to be one FTSE 100 index constituent. Index concentration levels vary over time.

Switching from the capitalization weighted to the equally weighted index version means cutting substantially the weightings in a few big stocks (shown on the right of the chart), such as Royal Dutch Shell, HSBC, BP, Glaxo Smith Kline and British American Tobacco.

Conversely, weightings in the smaller stocks on the left of the chart all get a boost in the equally weighted version of the FTSE 100 index.

Why might investors use an equally-weighted index? First, it’s an easily understandable way to address concerns about concentration in cap-weighted indexes and to boost levels of diversification.

Second, academic studies have highlighted the performance of equally weighted indexes over time. Researchers often attribute any high performance of equally weighted indexes to their higher weighting in smaller-capitalization stocks (which have historically offered a return premium to large caps). More recent evidence regarding the small-cap premium is more mixed, however.

There are drawbacks to equal weighting indexes for those operating index-replicating financial products. These indexes demonstrate higher levels of turnover than cap-weighted indexes (which are largely self-rebalancing), which implies higher administration costs for index-replicating products.

 

 

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