What is an Unweighted Index
An unweighted index is comprised of securities of equal weight; in other words, an equivalent dollar amount is invested in each of the index components. For an unweighted stock index, one stock's performance will not have a dramatic effect on the performance of the index as a whole. This differs from weighted indexes, where some stocks are given more percentage weight than others, usually based on their market capitalizations.
BREAKING DOWN Unweighted Index
Unweighted indexes are rare, as most indexes are based on market capitalizations, whereby companies with larger market caps are accorded higher index weights than companies with lower market caps. The most prominent of unweighted stock indexes is the S&P 500 Equal Weight Index (EWI), which is the unweighted version of the widely-used S&P 500 Index. The S&P 500 EWI includes the same constituents as the capitalization-weighted S&P 500 Index, but each of the 500 companies is allocated a fixed percentage weight of 0.2%.
Implications for Index Funds and ETFs
Passive fund managers mechanically construct their index funds or exchange-traded fund (ETF) based on leading indexes like the S&P 500 Index. Most choose to mimic their investment vehicles on market capitalization-weighted indexes, which means that they must buy more of the stocks that are rising in value to match the index, or sell more of the stocks that are declining in value. This can create a circular situation of momentum where an increase in a stock's value leads to more buying of the stock, which will add to the upward pressure on the price.
The reverse is also true on the downside. An index fund or ETF structured on an unweighted index, on the other hand, sticks to equal allocations among the components of an index. In the case of the 500-stock index, the fund manager would periodically rebalance investment amounts so that each has around 0.2% of the total. This is considered a passive approach to contrarian style investing, in which more funds are invested in stocks that have declined ("out-of-favor" stocks) and money is taken away from popular, or overbought, stocks that have increased in value.