Market Value Weighting Versus Equal Weighting

Once a set of holdings is chosen, how much of each to hold remains an open question. The two common answers produce portfolios with quite different characteristics.

Market value weighting reflects the market

Weighting each holding by its market value means the portfolio mirrors how capital is actually allocated across the market as a whole.

It has a practical advantage that is easy to overlook. As prices move, the weights adjust automatically, so no trading is needed to maintain them.

This makes it the cheapest approach to run, which is a large part of why most index funds use it. Turnover comes only from index changes rather than from price movement.

Concentration is the consequence

When a small number of companies grow much larger than the rest, they come to dominate the index and therefore the portfolio.

Holders may find that a fund described as broadly diversified has a substantial share of its value in a handful of names and often a single sector.

This is a faithful reflection of the market rather than a defect in the method, but it means the diversification obtained can be narrower than the number of holdings suggests.

Equal weighting spreads the exposure

Equal weighting holds the same amount in each constituent regardless of size, which reduces the influence of the largest companies substantially.

The resulting portfolio tilts towards smaller companies within the index, since the smallest constituents receive the same weight as the largest.

That tilt is the main source of any difference in behaviour, and it means the approach behaves differently depending on whether larger or smaller companies are performing better.

Maintenance costs differ substantially

Equal weights drift as soon as prices move, so the portfolio must be rebalanced periodically to restore them.

That rebalancing involves selling what has risen and buying what has fallen, which generates turnover and dealing costs that a market value approach avoids entirely.

The cost difference is one reason equal-weighted funds typically carry higher charges than their market value equivalents on the same underlying index.

Neither is a neutral default

Market value weighting embeds the market's current judgement about relative size. Equal weighting embeds a deliberate decision to ignore it.

Both are choices with identifiable consequences for concentration, turnover and which companies drive the outcome.

Knowing which method a holding uses explains a large part of why two funds covering the same market can diverge for extended periods.