1. Price-weighted indexes
In the case of a price-weighted index, the trading price of the index is determined based on the trading prices of the individual securities (stocks) that make up the index basket (the components). In other words, higher-priced stocks will have a greater impact on the movement of the index than those with lower prices. This is because their price is “weighted” more heavily.
One of the most famous price-weighted indexes is the Dow Jones Industrial Average (DJIA). It consists of 30 different components. In this index, higher-priced stocks move the index more than those with lower trading prices; therefore, they are price-weighted.
2. Value-weighted indexes
In the case of a value-weighted index, the relative weight of each stock in the index is calculated based on the number of shares outstanding and the stock price for each. When determining the weight of each stock in a value-weighted index, a simple basic formula can be used without complication. All you need to do is multiply the stock price by the number of shares outstanding.
For example, suppose you have stock ABC with 6 million shares outstanding trading at $15. This means its weight in the value-weighted index is $90 million (15 × 6). On the other hand, stock XYZ trades at $30 and has only one million shares outstanding. Its weight is $30 million (30 × 1).
Using the above case, in a value-weighted index, stock ABC will have a greater impact on the movement of the index. However, in the case of a price-weighted index, it will have a lower value, as its price is lower. Some value-weighted indexes include the well-known MSCI index family and the widely tracked S&P 500 index. These indexes are sometimes referred to as “market capitalization-weighted indexes.”
3. Unweighted indexes
The third variation of weighted indexes is the unweighted index; some call it an “equal-weighted index.” All stocks, regardless of the number of shares or price, have an equal impact on the index price. Price changes in the index rely on the percentage return of each component.
Suppose there are three stocks in our unweighted index example: ABC, XYZ, and MNO. Regardless of how many shares you hold of each stock or the actual trading price, look at the price movement percentage. So, if ABC is up by 50%, XYZ is up by 10%, and MNO is up by 15%, the index will be up by 25% = (50 + 10 + 15) / 3 (the number of stocks in the index).
This is based on an arithmetic mean, but some unweighted indexes may use a geometric mean calculation as well. In this case, the formula will change to (1.5 + 1.1 + 1.15) [1/3].
In most cases, the geometric formula will produce a slightly lower percentage than the arithmetic formula; in any case, it should be very close.
Conclusion
While there are other types of weighted indexes, such as revenue-weighted indexes, fundamental-weighted indexes, factor-adjusted indexes, and even trade-adjusted indexes, the three mentioned here are the most commonly used with ETF funds.
Unlike funds that are selected by a manager, most ETFs are passive as stocks are automatically selected to match a particular market aspect. Depending on the type of fund, different proportions of underlying stocks are held. Because ETFs are automated, they usually carry lower operational costs.
There is much debate over which type of weighted index is best. Ultimately, it depends on your personal situation.
Questions
Frequently Asked Questions (FAQs)
What is the volume-weighted average price?
The volume-weighted average price is a technical indicator that traders can use to plan their entry and exit points. This indicator tracks the price of the security, just like other moving average indicators, but it takes into account the volume of shares. This weighting gives more importance to price movements that occur with higher trading volume.
How can I find the yield of a price-weighted index?
The easiest way to find the yield of a price-weighted index (or any type of index) is to use charting and finance software. Websites like TradingView and Yahoo! Finance provide detailed historical data for many different indices around the world. Brokerage accounts usually also provide these tools.
Source: https://www.thebalancemoney.com/different-types-of-weighted-indexes-1214780
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