New Investing Regime May Require Fresh Weighting Approaches

Experienced advisors know that the strategies that worked in one investing environment may not shine as bright in the next.

On the other hand, it’s hard to argue with the returns offered by the S&P 500 and other broad-based domestic equity benchmarks. Scores of active managers have failed to beat those benchmarks with any irregularity and clients love plain vanilla, pure beta exchange traded funds and index funds because those products often beat their active rivals and usually do so with nominal fees.

Indeed, the S&P 500 is benchmark of benchmarks, particularly when it comes to U.S. stocks, but that doesn’t mean it’s perfect. It’s not designed to be, but it is effective. That said, 2022 marked the first time in seven years that more than half of the equity-based ETFs listed in the U.S. topped the S&P 500.

That’s not cause for alarm, but it does underscore the point that advisors need to be flexible and tactical when it comes to clients’ equity allocations. Fortunately, ETFs allow advisors to efficiently accomplish that objective, often doing so with favorable annual costs.

Be Flexible, Particularly if Growth Lags

As advisors well know, one of the primary reasons why the S&P 500 and other cap-weighted domestic equity indexes thrived in recent years was due to the significant returns notched by a small number of mega-cap growth stocks. Those include Apple (NASDAQ:AAPL), Microsoft (NASDAQ:MSFT) and Amazon (NASDAQ:AMZN), among others. As the market values of those stocks swelled, so did their weights in traditional equity gauges.

“We believe two key factors made the S&P 500 Index unusually difficult to beat in recent years. First, many of the index’s top holdings posted exceptional returns. From 2016-2021, Apple (+552%), Microsoft (+482%), Alphabet (+266%), and Amazon (+345%) were each among the index’s best performing decile.1 Second, because the index is market capitalization weighted, allocations to these stocks increased significantly over time, magnifying their impact,” according to First Trust research. “On 12/31/16, these four stocks made up less than 10% of the S&P 500 Index.2 By 12/31/21, their weightings had increased to nearly 21%.3 During the same 5-year period (2017-2021), an average of 57% of S&P 500 Index constituents underperformed the index (chart 2). This narrow market corresponded with a scarcity of equity ETFs that managed to beat the index.”

History confirms why advisors should be flexible. Over time, significant percentages of S&P 500 member firms lag the index. However, alterations on market breadth can turn positive for clients.

“4 If history repeats, we believe this may be good news for ETF investors, as market breadth and ETF outperformance have gone hand in hand. On average, the percentage of US equity and sector ETFs that outperformed the S&P 500 Index from 2000-2005 surged to 67%.5 This pattern continued during the 2022 bear market, when many of the S&P 500 Index’s largest constituents faltered and a higher percentage of its constituents outperformed the index, as well as a higher percentage of equity ETFs,” adds First Trust.

Practical Ideas for Changing with the Times

One inference that can be made from more than half of the equity ETFs in the U.S. beating the S&P 500 last year is that times are changing. Advisors need to roll with those punches. Fortunately, they can do that, potentially to the betterment of client outcomes, without embracing exotic fare. Take the case of equal-weight ETFs.

“We believe equally weighted ETFs are the simplest solution for avoiding the top-heavy concentration found in many market-cap weighted ETFs. For example, the First Trust NASDAQ-100 Equal Weighted Index Fund (QQEW) invests in the same 100 stocks as the market-cap weighted Nasdaq 100 Index. However, QQEW assigns a 1% weighting to portfolio holdings each quarter. For reference, the Nasdaq 100 Index allocated 41% to its top 5 holdings, as of 12/31/22,” notes First Trust.

With value shining bright in recent years and other factors potentially ready to join that party, some factor-based ETFs may be worthy of consideration, too.

“In our opinion, certain factor-based ETFs—often referred to as “strategic beta” funds—may also benefit from a broader equity market. These ETFs favor a variety of characteristics that have historically produced above average returns over time,” concludes First Trust. “For example, the First Trust Large Cap Core AlphaDEX® ETF (FEX) screens for value, momentum, and profitability when selecting stocks and assigning portfolio weightings. Stocks that score better for these metrics have larger allocations, while the worst scoring stocks are eliminated. Based on this methodology, the top 10 holdings of the S&P 500 Index made up just 1.3% of FEX, as of 12/31/22.”

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