The S&P 500 is a market capitalization weight index. This means that larger companies make up larger percentages of the index than smaller companies. The percentage is calculated by taking the market capitalization of the stock and divided by the total market capitalization of the entire index. For example, the largest company in the S&P 500 index is Microsoft which currently accounts for 4.30%. Apple is the second-largest company at 3.73%. Currently, the top 10 stocks account for 21.54% and the top 50 accounts for 50.45%. This is a reasonable way to build the index since presumably larger companies have a greater influence on the economy and the market.
S&P 500 Equal Weight Index
An alternative to the market capitalization strategy is the equal weight strategy. Invesco offers an ETF called Invesco S&P 500® Equal Weight ETF (RSP). This ETF invests in all 506 stocks equally, so each stock represents approximately 0.198% of the index. The RSP fund rebalances quarterly, so the percentages do drift between rebalancing.
Here is a screenshot from ETFdb.com ETF Comparison Tool.
Here is a screenshot of the top 15 holdings.
As you can see, the distribution is roughly equal across all stocks in an equal weight index.
Equal Weight Index Pros and Cons
Although both funds invest in the same 506 stocks, the equal weight index is more diversified. Instead of having 50% of the portfolio concentrated in the top 50 stocks (which only represent 10% of the index), the investment is spread out evenly across all stocks.
The one main concern is sector allocation. When you invest in the standard S&P500 index, the sector allocation is representative of the overall economy. However, when you invest in the equal weight index, the sector allocation is representative of the number of companies in each sector.
Fortunately, the equal weight methodology doesn’t throw the sector allocation entirely out of the window. In fact, there is a smaller difference between the largest vs. the smallest sector. For example, in the capitalization weight S&P 500, the largest sector is Information Technology at 22.05%, and the smallest sector is Materials at 2.70%. In the equal weight index, the largest sector is still Information Technology but at 14.23% and the smallest sector is Communication Services at 4.65%.
If you want your portfolio to be representative of the general economy, it is worth noting that an equal weight ETF will throw the sector allocation off.
If you look at a chart like this one below or look at marketing material from companies that offer equal weight ETF, you might assume that equal weight is a superior strategy.
In my opinion, equal weight methodology does not automatically create superior performance. A better explanation is equal weight index is more similar to a mid-cap fund because the bottom 450 stocks now represent 80% of the index performance instead of the original 50%.
Here is a chart of how RSP compares to SPY and MDY from Yahoo Finance.
As you can see, RSP is closer to the performance of SPDR S&P MidCap 400 ETF (MDY) and does better than the standard S&P 500 when MDY outperforms SPY. When mid-cap underperforms, as it has in the past few years, RSP performs worse than the S&P 500.
Another way to confirm this theory is to look at the Morningstar Style Box of these three ETFs compared side-by-side. As you can see, RSP has a much better distribution between large-cap and mid-cap stocks, and it is more or less the average of MDY and SPY.
Equal weight ETFs are, on average, more expensive than their standard counterparts. For example, RSP has an expense ratio of 0.20% vs. SPY expense ratio of 0.09%.
Since we can do a reasonably good job of replicating the long-term performance of RSP using a mix of mid-cap and large-cap funds, you might be better off investing in the lower expense options.
Value vs. Momentum
When you invest based on market capitalization, you let momentum drives the price. As the stock price goes up, the stock becomes a more significant portion of the index. For example, large successful companies like Microsoft and Apple contributed a massive amount to the index growth.
On the other hand, an equal weight index fund has to rebalance regularly to keep the equal distribution. This means they cannot let winners ride the upward momentum. Each time they rebalance, they sell a little bit of the winners and buy more of the losers. This is more of a value investing approach where you buy low and sell high.
The standard market capitalization weight approach has a very low turnover because sales only happen when stock leaves the index, and a new one is added to replace the outgoing one.
For example, according to MarketWatch, SPY has a turnover ratio of 2% vs. MDY 17% vs. RSP 19%.
Since equal weight index has to rebalance regularly, it generates a lot of short-term capital gains as winners are sold to reduce the percentage back down to the correct allocation.
For example, according to Fidelity, RSP generates 13.10% potential capital gains vs. -0.4% for SPY and -10.78% for MDY.
I personally like the idea of using an equal weight strategy for its greater diversification benefit and its value investing approach. However, it doesn’t appear that equal weight strategy is inherently superior to market capitalization weight strategy. In fact, it has several disadvantages, such as higher expenses, less tax-efficient, and lower momentum.
Pinyo Bhulipongsanon is the owner of Moolanomy Personal Finance and a Realtor® licensed in Virginia and Maryland. Over the past 20 years, Pinyo has enjoyed a diverse career as an investor, entrepreneur, business executive, educator, financial literacy author, and Realtor®.