As advisors are keenly aware, exchange traded funds and index evolved over the years to encompass weighting strategies beyond market capitalization.
While some of those methodologies are relatively new or unappealing to asset allocators, one that’s battle-tested in terms of both age and performance is equal-weighting. In simple terms, an equal-weight equity-based ETF or index fund assigns, upon rebalancing, assigns the same weight to all of its components. So if there are 100 stocks in the fund, the member firms receive allocations of 1% apiece when the fund rebalances.
That methodology took on added relevance in recent years when supposedly diversified broad market cap-weighted funds sported large weights to a small number of securities, meaning those funds exposed clients to concentration risk.
Consider this: Even with last year’s weakness in tech and growth stocks, Apple (NASDAQ:AAPL) and Microsoft (NASDAQ:MSFT) combine for more than 11% of the cap-weighted S&P 500 and six of that index’s top 10 holdings are growth stocks. Certainly in the case of the former point, that doesn’t equate to “diversification” and it could easily single concentration risk.
Equal-Weight to the Rescue
The S&P 500® Equal Weight Index, which is the gold standard among equal-weight equity benchmarks, celebrated its 20th birthday earlier this month, making now an appropriate time to discuss the benefits of this weighting scheme.
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.
“Arguably the biggest driver of the S&P 500 Equal Weight Index’s outperformance was its smaller size exposure. Having more (less) exposure to the smaller (larger) names in the S&P 500 explained over 50% of the S&P 500 Equal Weight Index’s relative returns, historically, and it was useful when exploring equal weight’s impact on risk/return,” according to S&P Dow Jones Indices.
Naysayers are free to criticize all they want, but with value on a two-year winning streak over growth and with many market observers forecasting another year of small-cap outperformance, strategies that lean into the size and value factors have the potential to reward clients in 2023.
Other Reasons for Advisors to Consider Equal-Weight
To be sure, equal-weight isn’t a two-trick pony (size and value). There are other compelling reasons to consider deploying this methodology in client portfolios.
“In addition to the potential relevance of the S&P 500 Equal Weight Index to those looking for large-cap U.S. equity exposure, there are several reasons why investors may wish to use the S&P 500 Equal Weight Index as a supplemental benchmark for large-cap U.S. equity managers. For example, the equal weight index may be a more suitable benchmark, given that it appears many active managers have historically been closer to equal weighting than cap weighting in their portfolio construction,” adds S&P.
Add to that, the S&P 500 Equal Weight Index historically offers more exposure to that index’s best stocks than its cap-weighted counterpart. From 2003 through the end of 2022, the equal-weight index had larger weights to the S&P 500 names in the 80th through 100th percentiles in terms of return attribution than did the cap-weighted index.