Most indexes such as the S&P 500, Nasdaq, MSCI World, and Russell 2000 are market cap weighted. The major exception is the Dow Jones industrial average. The granddaddy of the indexes is price weighted - essentially it’s a straight average of the share price (in truth it’s more complicated because of changes made to the index over the years, but that’s the basic principle). By virtue of being market cap weighted, larger companies impact the index more than smaller companies Market capitalization is simply the number of outstanding shares multiplied by the share price. So for example, let’s say I create index called AskDong 2 with two stocks, GOOG (Google) and IRBT (iRobot the maker of the Roomba) . GOOG has a market cap of 165 billion, and IRBT a market cap of $412 million. The resulting index would be heavily skewed towards GOOG with IRBT barely making a dent in the price of the index. The index would consist of 99.8% the price GOOG, and .2% IRBT.

While I think there’s very little disagreement that that market cap weighted indexes are a great measure of broad markets, some people believe that from an investment standpoint market cap index mutual funds are somewhat inherently flawed. Because market cap is affected by the share price, it’s inevitable that when someone buys into a index fund they are effectively buying more of the “hot” stocks, and less of the sagging ones. Mutual fund companies realizing this and that there’s money to be made marketing an alternative have introduced Equal Weight Index Funds.

Equal Weight Index funds eschew the market cap weight, and allocate dollars equally to each share that makes up the index. Example of such funds are the Rydex S&P Equal Weight Fund, RSP and Nasdaq 100 Equal Weighted, QQEW. Individuals who believe that equal weight index funds are superior generally tout the the increased exposure to the undervalued stocks since an equal weight index will own as much of the sagging companies as the winners.

Personally, I believe if someone who’s only investment is a S&P 500 or Total Market index fund then that person should consider an equal weight index fund just because they are not giving enough weighting to mid and small cap stocks. However if someone is properly invested in different market indexes already, they mostly likely have enough exposure to undervalued shares. More fundamentally, by assuming that those shares are “undervalued” implies that those shares will rise in value. The fact is poorly performing shares are often poorly performing because the companies are inherently flawed. Unlike traditional Index Funds which make no judgement about the market, Equal Weight Index Funds implicitly are contrarian to the market as they tend to chase the laggards.