There are three main types of indexes: price-weighted, value-weighted, and pure unweighted.
- With a price-weighted index, the index trading price is based on the trading prices of the individual stocks that make up the index basket; higher prices are given more weight.
- In value-weighted indexes, the number of outstanding shares is multiplied by the per-share price. This determines the weighting of each stock in the index.
- Unweighted indexes value each stock in the basket equally.
1. Price-Weighted Indexes
In other words, the stocks with higher prices will have more impact on the movement of the index than stocks with lower prices. That's because their price is "weighted" higher.
If a stock goes from $100 to $110, because its price is higher, it will move the price-weighted index more than a stock that goes from $20 to $30. It doesn't matter that the percentage move is greater for the lower-priced stock.
One of the most popular price-weighted indexes is the Dow Jones Industrial Average (DJIA). It consists of 30 different components. In this index, the higher-priced stocks move the index more than those with lower trading prices; hence, they are price-weighted.
2. Value-Weighted Indexes
In the case of a value-weighted index, the amount of outstanding shares comes into play. To determine the weight of each stock in a value-weighted index, there's a basic formula that can be used without getting too complex. All you have to do is multiply the price of the stock by the number of outstanding shares.
Let's say stock ABC has 6 million outstanding shares and trades at $15. That means its weight in the value-weighted index is $90 million (15 x 6). On the other hand, stock XYZ is trading at $30, and has only 1 million outstanding shares. Its weight is $30 million (30 x 1).
Using the case above, in a value-weighted index, ABC would have more impact on the movement of the index. But in a price-weighted one, it would have less value since its price is lower. Some value-weighted indexes are the popular MSCI family of strategy indexes as well as the widely tracked S&P 500 index. These are also sometimes called capitalization-weighted indexes,
3. Unweighted Indexes
The third variation of weighted indexes is the unweighted index; some call it the equal-weighted index. All stocks, regardless of share volumes or price, have an equal impact on the index price. The price change in the index is based on the percentage return of each component.
Let's say there are three stocks in our unweighted index example: ABC, XYX, and MNO. Regardless of how many shares you have of each stock or the actual trading price, look at the percentage of price movement. So if ABC is up 50% and XYZ is up 10% and MNO is up 15%, the index is up 25% = (50+10+15) / 3 (the number of stocks in the index).
This is based on an arithmetic average. But some unweighted indexes will use a geometric average calculation as well. So then the formula would change to (1.5 + 1.1 + 1.15) [1/3].
In most cases, the geometric formula will generate a slightly lower percentage than the arithmetic formula; either way, it still should be fairly close.
The Bottom Line
While there are other types of weighted indexes, such as revenue-weighted indexes, fundamentally-weighted indexes, factor- and even float-adjusted indexes, the three outlined here are the ones most often used with ETFs.
Unlike funds that are chosen by a manager, most ETFs are passive with stocks selected automatically to match a particular aspect of the market. Based on the type of fund, different proportions of the underlying stocks are held. Because ETFs are automated, they typically carry lower operating costs.
There are many arguments about which types of weighted indexes are best. In the end, it depends on your personal situation.
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