Undoubtedly, the Standard & Poor’s (S&P) 500 Index is a widely used benchmark for many professional financial managers as well as individuals who manage their own investments.
But there is a new way methodology of weighing the S&P 500 index which has, over the past several years, gained steam. As a result, it has seen more investors’ inflows and returns. This methodology is the Equal Weight Index. But before we dive into it, let’s first briefly understand or refresh ourselves on how the S&P 500 Index works.
Traditional S&P 500 Index
In a nutshell, the way the S&P 500 Index works are that it is weighted based on the capital of each company or the price times the total shares outstanding, within the index. So, for example, Apple, Inc. has the highest weighting since it has the largest capitalization:
From the chart above, we can see how influential the top five companies of the S&P 500 company index really are. These five companies together represent more than 10% of the entire index. Moreover, three out of these five companies are of the same sector: information technology. And although not captured here, the top 10 companies in the S&P 500 list represent roughly 20% of the entire index.
Equally Weighted Index Is Just That
The concept of Equal Weighting to an index stared back in January 2003 for people skeptical of overall market efficiency. From a pure price standpoint, it ignores what the stock is doing. Equally weighted means each stock is weighed exactly the same.
So in continuing with the example of Apple, Inc., instead of a weight of 3.79% based on its capitalization, it’s weighting in the Equal Weighted Index would be 0.2% (1 / 500 X 100% – the same as all the other companies in the Equal Weight Index).
The companies listed are still the same as in the capitalized S&P 500.
The weighting within each sector is different as well between capital indexing and equal weight indexing; it’s really a matter of quantity in the latter. That is, sector weighting in the equal weight index is determined by the number of companies within that sector. Plain and simple, if there are more companies in a particular sector, its weight will be higher.
Here is a sector breakdown and allocation at the time I obtained it from S&P Dow Jones Indices:
Now compare the above to the sector breakdown and allocation S&P 500 Equal Weight Index:
It may not seem a whole lot different at first glance. But if you look at the sector breakdown, you’ll see that Information Technology and Consumer Discretionary did a flip-flop in their weight rankings. That is, Information Technology went from first to the fourth sector in its weight, while Consumer Discretionary went from fourth to first.
The percentages only changed by 2.9% in Consumer Discretionary, but the percentage change in Information Technology is 11.7%!
This means that there are more companies within the S&P 500 Index in the Consumer Discretionary sector as compared with Information Technology. As a result, the combined percentages of 0.2% for each company categorized in Consumer Discretionary contribute to its overall higher sector weight.
How Can The Equal Weight Indexing Help Me?
Like anything, Equal Weight Indexing has advantages and disadvantages. The decision to invest in them depends on the importance you give to each advantage or disadvantage.
Advantages of Equal Weight Indexing:
- Removal of single stock concentration risk.
- Reduction in the excess exposure to one particular sector in case of a downturn (e.g., financial sector during the Great Recession).
- More even diversification across companies within the index.
- Adoption of value-investing to maintain equal weighting accomplished by selling shares that have raise in price and buying shares that have decreased in price.
Disadvantages of Equal Weight Indexing:
- Has proven to be more volatile. This makes sense since the equal weight gives more representation to small-cap stocks as compared to capitalization weighting.
- Needs to be rebalanced quarterly to maintain an equal weighting among stocks.
- This is a double-edged sword. It results in the classic strategy of buy low and sell high as you are adjusting the weight, but can also lead to higher transaction costs. Still, the transaction costs for an equal weight index are below those of actively managed mutual funds.
We already know that small and mid-size cap companies come with more risk. But we also know that they can produce higher returns when compared to large-cap. And depending on whether it’s a bull market or bear market will prove how powerful or dangerous equal-weight indexing can be.
Million Dollar Question: What About Performance?
Overall, equal weight indexing has performed better, that is if you can stomach the volatility. This is when bull markets occur predominately. In bear markets especially, equal weight indexing does produce higher volatility. Research has shown this to be attributable to the higher weight distributed to small and mid-cap stocks.
International indexes that are equally weighted have also outperformed their market capitalization counterparts.
Seeking Alpha mentions a popular Equal Weight Index fund: The Guggenheim S&P 500 Equal Weight ETF (RSP). When compared with the SPDR S&P 500 ETF (SPY), RSP returned double the investment with a risk or volatility of 20%.
In sticking with the RSP Equal Weight ETF (RSP), I decided to compare it myself against a favorite of mine; Vanguard’s funds. When comparing RSP with Vanguard’s S&P 500 Index Fund (VFINX), the Guggenheim fund again performed significantly better:
It’s important to note that although the performance is better for RSP, it comes at a cost. RSP’s expense ratio is 0.33%, whereas VTI’s is 0.14% – less than half.
Perhaps an equal weight fund such as RSP may be a good addition to a portfolio to add diversification in a more even manner and provide greater long-term performance.
Since the introduction of equal weight indexing, it has continued to experience more and more inflows from investors. This could be due to performance, its passive operational nature similar to index funds and ETFs, and lower fees at least when you compare it with managed mutual funds.
- Do you believe the equal weight index strategy is more advantageous than capital indexing?
- Do you own shares of the Guggenheim S&P 500 Equal Weight ETF?
- Does the equal weight index take the passive investing approach to a level that may be dangerous?
I use Personal Capital because (1) it’s free, (2) it tracks all of my accounts and overall net worth, (3) my account balances automatically update, (4) it shows how my investments are diversified and allocated in various sectors, and (5) can use built-in tools like “Investment Checkup” to get….wait for it…free personalized advice!