Why do equal-weighted indexes have higher rebalancing costs than cap-weighted indexes?

Equal-weighted indexes assign every constituent the same weight regardless of market cap. After any period, stock prices diverge and weights drift away from equality, requiring periodic rebalancing back to equal weight.

Why Rebalancing Is Necessary:

Suppose an equal-weight index has 5 stocks, each starting at 20% weight. After one month:

Stock	Return	New Weight
Avalon Pharma (fictional)	+15%	22.1%
Bristow Mining (fictional)	-8%	17.7%
Calloway Retail (fictional)	+3%	19.8%
Devereaux Systems (fictional)	+20%	23.1%
Eastgate Financial (fictional)	-5%	18.3%

To restore equal 20% weights, you must sell winners (Avalon, Devereaux) and buy losers (Bristow, Eastgate). This is inherently contrarian.

Sources of Higher Cost:

1. Turnover: Every rebalancing date requires trades in every constituent. A 500-stock equal-weight index needs 500 trades each quarter.
2. Small-Cap Drag: Equal-weight gives the same weight to a $500M company as a$500B company. Small caps have wider bid-ask spreads and lower liquidity, increasing transaction costs.
3. Frequency: Most equal-weight indexes rebalance quarterly. Cap-weighted indexes need no rebalancing for price changes — weights adjust automatically.
4. Tax Inefficiency: Selling winners creates realized capital gains. Cap-weighted indexes rarely trigger taxable events from price-driven weight changes.

Cost Comparison:

Factor	Cap-Weighted	Equal-Weighted
Rebalancing frequency	Rare (reconstitution only)	Quarterly
Annual turnover	~5%	~20-30%
Transaction costs	Very low	Moderate to high
Small-cap exposure	Minimal	Significant
Tax efficiency	High	Lower

Exam Tip: The CFA exam contrasts cap-weighted and equal-weighted indexes. Remember: equal-weight has a small-cap tilt and contrarian bias (sells winners, buys losers), while cap-weight has a large-cap tilt and momentum bias.

Practice index weighting comparisons in our CFA Level I question bank.