Equal Weight

When Wall Street firms put together those stock indices you see on the news (the Dow, the Nasdaq, the BRIC-Produced Dog Food Industrial Futures Average), one of the considerations they have to keep in mind is weighting. This term refers to the amount of each component make up the index or fund.

Each index has a bunch of stocks that it tracks. Take the Dow, the most famous (and possibly most useless) of the marquee stock indices. It includes 30 stocks, meant to reflect the U.S. economy, more or less. It's got stocks like Apple and Exxon Mobil and Intel (and 27 others, but we're already bored of listing them all).

Other indices track different sectors or groups of stocks. Tech indices for the tech sector. Oil indices for the oil sector. You get the idea.

When the companies that make these indices put them together they have to figure out 1) what stocks to include, and 2) what weighting to give them. The weighting is the amount of each stock that will get used to mathematically figure out the value of the index. It's the proportion of each stock that make up the index.

Think of it like a recipe. You need a cup of sugar, two cups of flour, a teaspoon of vanilla, etc. For a tech index, you might need six parts Apple, two parts Intel, five parts Google, etc.

Most indices are weighted by market cap. You can use pretty much anything that makes sense. Equal weight is one choice. It means that all the stocks have the same weight. The ratio is one-to-one across the board. They're all equal.

It sounds kind of vaguely fair, though it doesn't really make a lot of sense in practice, at least not for tracking indices, like the Dow or S&P 500. It's like a cake, where all the ingredients are exactly equal: one cup sugar, one cup flour, one cup vanilla, one cup baking powder. You'll probably end up with...a weird cake.

Still, some people prefer the equal weighting, to such an extent that there are sometimes equal-weight versions of indices that otherwise have market weighting. For example, there's an Equal Weight S&P 500 ETF.

Equal weight funds are naturally more diverse than market weight ones, which pile up on the bigger-cap stocks. Also, there are studies that suggest that equal-weight funds outperform market-weight ones, possibly because smaller-cap stocks inherently have more growth potential than bigger-cap ones (more room to grow). In a market-weighted fund, you definitionally get more of the biggest companies, which (because they're big) have a harder time maintaining high growth rates.

So market-weighted indices more closely match what's going on in the real life sectors, and probably have better explanatory value. Equal-weight funds perform better, so might provide a better investment.