Your S&P 500 index fund isn’t doing what it’s supposed to do. Consider an equal-weighted index instead.
Over the last few weeks, I’ve presented data showing that since the S&P 500 is a market-capitalization weighted index, it presents a distorted view of the market.
Here’s a summary of my articles from March 27th and April 1st:
- The combined weighting of just 2 companies — Apple (AAPL) and Microsoft (MSFT) — now accounts for more than 13% of the S&P 500 index. That’s an all-time high.
- The entire market is now virtually made up of 9 stocks. Without those 9, the S&P 500’s gains in the first quarter would have been negative. Additionally, just 3 companies contributed to 91% of the gains!
The bottom line is this:
If you invested in a S&P 500 index fund to diversify your risk and gain exposure to the broad market, you’re not getting what you thought you were. The top heaviness of the index is exposing you to significant concentration risk.
Thankfully, there are other ways to invest in the S&P 500 besides the traditional market-weighted ETFs.
Equal-Weighted Index ETFs
In an equal-weighted ETF, each stock is given the same weight, regardless of its market cap. This means that smaller companies have the same influence on the index’s performance as larger ones.
That’s much different than index ETFs where the weight of each stock is determined by its market capitalization. (In simple terms, market cap is the value of a company calculated by multiplying its share price by the number of outstanding shares.)
Of course, neither ETF is perfect. Here are some pros and cons of each:
Equal Weighted S&P 500 Index ETF
Pros:
- More diversified, as it doesn’t rely on a few big companies for performance.
- Provides better exposure to small and mid-cap stocks.
- May outperform market-cap-weighted ETFs during specific market conditions, such as when smaller companies lead the market.
Cons:
- Higher portfolio turnover, as frequent rebalancing is required to maintain equal weights.
- Typically higher expense ratios due to increased trading costs.
- May underperform market-cap weighted ETFs during periods when large-cap stocks dominate the market.
Market-Cap Weighted S&P 500 Index ETF
Pros:
- Dominant companies carry more weight, which can lead to better performance when large caps outperform small and mid-cap companies.
- Tends to have lower turnover and lower expense ratios, which can save on trading costs.
Cons:
- Heavy concentration in large-cap stocks may lead to underperformance in specific market conditions.
- Less diversified compared to equal-weighted ETFs, as a few big companies drive performance.
Which is the Better Performer?
The answer to that question depends on your timeframe. The equal-weighted index performed better over the last 3 years. If you stretch that to 5 years, however, the market-cap weighted version is the winner.
When you look at long-term data, it’s a virtual tie, especially when you factor in transaction costs and management expenses.
Since 1971, which is how far back S&P Global has calculated the equal-weight version’s performance, the equal-weight version has produced a dividend-adjusted return of 12.2% annualized, in contrast to 10.8% for the cap-weighted version. But the equal-weight version’s higher return was produced with 13% more volatility, which is one measure of risk. On a risk-adjusted basis, the two are almost neck-and-neck, with equal-weight slightly ahead.
Source: MarketWatch
Why I Prefer an Equal-Weighted Index Right Now
If the performance of both weighting styles is essentially the same, why am I pushing equal weight so much?
That’s a fair question.
It comes down to alignment with investor expectations.
Typically, when people invest in the S&P, they want risk diversification and exposure to the broad market. That’s not the case any more since the index is historically more top heavy than ever.
So, from an expectation standpoint, an equal-weighted index gives investors more of what they’re looking for (i.e. diversification and broad market representation).
If you fall into this category, an equal-weighted S&P 500 index ETF like the Invesco S&P 500 Equal Weight ETF (RSP) may be a better fit for you than the more common SPY, VOO, or IVV, all of which are market-cap weighted.
But you can do even better with another type of weighting
Matching the return of the broad market is okay. But beating it is so much better!
One way you can accomplish that is by weighting the S&P 500 according to business fundamentals.
For example, the investment research firm, Research Affiliates, tested a sales-weighted index going back to the 1970s. They found that if you select the 500 largest stocks by sales, and weight the index by sales, it outperforms the S&P by 2.5% per year for 30 years!
Factoring in other fundamentals will give you additional performance edges as well.
The challenge, however, is identifying which metrics give you the greatest advantage.
Thankfully, that work is done for us with just a single ETF. To learn about this ETF and to receive additional stock recommendations and portfolios, become a premium member of The Antagonist.
There’s also a free option that gives you access to educational articles, market analyses, and discussion threads.
Good investing,
Jason
Disclaimer: This article is for informational purposes only. It is not investment advice, nor is any other content on this site. See the full disclaimer here.