Equal-Weight Could Again Have Its Day

With a significant chunk of the S&P 500’s 2023 gains attributable to the “magnificent seven” – all of which are mega-cap growth stocks – it’s not surprising that some advisors and investors are eschewing smaller stocks and the related funds.

Through Nov. 20, the S&P 500® Top 50 was trouncing the S&P SmallCap 600 Index. There are other factors explaining the struggles of small-cap stocks this year, not all of which are directly the result of bias towards the magnificent seven, but the point is advisors have had little reason to direct client portfolios toward more volatile small-cap fare.

Struggles by smaller stocks are also confounding equal-weight strategies, which inherently tilt toward small-cap names. For example, the S&P 500 Equal-Weight Index was up just 3.6% year-to-date as of Nov. 20, badly lagging the 17.1% returned by the cap-weighted S&P 500 over the same span.

That might be enough to prompt advisors to ignore equal-weight funds, but perhaps the opposite line of thinking is more relevant because history indicates that when equal-weight experiences a lengthy period of lagging cap-weighted benchmarks, the former usually rebounds in significant fashion.

Equal-Weight History Matters

It’s often said that history doesn’t always repeat, but it often rhymes. In the case of a potential equal-weight resurgence, rhyming will be sufficient.

“Equal Weight has always managed to recover from deep losses. February 2001, February 2010 and March 2021 are three prime examples, post major events like the tech bubble, financial crisis and COVID-19 recession,” notes S&P Dow Jones Indices.

Interestingly, what adds to the relevance of examining equal-weight today are the points of criticism of this methodology. The S&P 500® Equal Weight Index and other equal-weight indexes have long-term track records of topping cap-weighted rivals – something critics assert is attributable to the size and value factors and not much else. Indeed, equal-weight has merit as a long-term strategy.

“The strategy’s small size, anti-momentum and value tilts are key performance contributors. Further, Equal Weight’s innate rebalancing mechanism of selling the winners and buying the losers is an important benefit of the mean reversion,” adds S&P.

Magnificent Seven Highlight Equal-Weight Allure

If history is a guide, equal-weight could be in store for a rally fairly soon because the strategy tends to rebound following periods of overt mega-cap leadership.

“The quandary at hand is that it’s difficult to know in advance when the inflection point of outperformance for Equal Weight will occur. Historically, we have seen that turning points have coincided with extremes in mega-cap outperformance,” concludes S&P.

Add to that, with small-cap equities historically cheap relative to large-caps and the macroeconomic environment showing signs of cooperating with smaller stocks, equal-weight could be poised to shake out of its 2023 funk.

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