Unweighted Index
Candlefocus EditorAn unweighted index methodology is a simple, straightforward way of representing an index. All securities in the index are given equal weighting without considering any additional factors about individual securities. It requires that the index constituents be re-balanced periodically to maintain their equal weights. It features higher turnover compared to a capitalization-weighted index and thereby exudes higher trading costs and taxation.
Unlike its weighted counterpart, unweighted indices can be used to measure absolute return on investments (ROI) with greater accuracy. It gives equal importance to each constituent of the index - regardless of its size - which prevents the index from being highly sensitive to any movement in the positioning of a single large constituent. This can prove to be especially helpful in emerging markets, where certain companies are making a celebrated debut but are often assigned a high weight in a capitalization-weighted index.
Due to its lack of weighting, an unweighted index in and of itself is not very informative. Rather, it is well-used to measure an index’s absolute return over a given period of time or to measure the distribution of returns of constituent stocks relative to the index. Since the performance of all stocks included in the index are considered equally, their overall trends and performance will be accurately represented in the unweighted index.
Unweighted indices can also be used to identify outperforming stocks. Studies suggest that stocks that track the index will outperform stocks that don't; this incentivizes investors to buy stocks that are in the unweighted index. Additionally, it can be useful to compare the performance of an unweighted index to a weighted index to gain insight into the relative performance of different sectors.
Ultimately, the value of unweighted indexes depends on investors’ intended application. Weighted indexes may be the better option if investors are looking for market insights, whereas unweighted indexes may be more appropriate for measuring individual performance of certain sectors over time.