Before discussing the benefits of equal-weight as an alternative to strategy market-capitalization, we need to define market capitalization weighting. A market-capitalization weighted index, as the name implies, sizes its positions proportionate to their respective market capitalizations – larger companies have larger weights, smaller companies have smaller weights. This confers some benefits – a market cap weighted index never has to rebalance because as market caps change, the weightings in the index automatically adjust to reflect these changes. Thus, by definition, cap-weighting over-weights previous winners.
In contrast, an equal-weight index sizes each position in the index the same. Every position in an equal-weight S&P 500 index will be weighted at .~2% on rebalancing day – which generally happens quarterly.
We believe the data supports that equal-weighted indexes offer several advantages over their cap-weighted counterparts, notably: higher returns and more stable sector exposure.
Potentially Higher Returns
In their research piece “Outperformance in Equal-Weight Indices” S&P Dow Jones Indices illustrates the outperformance of equal-weight across various indices of different size and geography. The historical outperformance has tended to be greater in larger market capitalization indices when compared to their small-cap counterparts. The authors cite the size factor and “anti-momentum” (since equal-weight indices rebalance by selling winners and buying losers) as the drivers of outperformance.
Since the S&P Indexology piece looks at returns through 2017, I updated to show trailing 3y and since 2001 returns.
RSP (Equal-Weight S&P 500 ETF) vs. SPY (S&P 500 ETF ) – 1/1/2001-12/28/2021
RSP vs. SPY - 3 Year Trailing Returns - 12/29/2018-12/28/2021
Though returns since 2001 are much better RSP, RSP has lagged SPY by ~14% on a trailing 3-year basis, driven largely by the recent dominance of mega-cap tech firms colloquially known as FAANMG (FB, AAPL, AMZN, NFLX, MSFT, GOOGL). The future will tell if this recent bout of equal weight underperformance represents an opportunity for investors.
Market-capitalization weighted indices can vary greatly in their sector exposure through time. Because they overweight previous winners, they can have significant exposure to the wrong sector at the wrong time – such as technology stocks during the bubble and financials prior to the global financial crisis.
This excellent chart, also from S&P indexology, displays the sector weightings through time of the S&P 500 vs. the S&P 500 Equal Weight index. The sector exposure is much more stable in the equal-weight version of the S&P 500.
Howard Marks, founder of Oaktree Capital, wrote about this phenomenon in his April 2001 memo:
“Thirty years or so ago, investors began to concede that while it was desirable to participate in the stock market, it wasn’t worth trying to beat it. Under prodding from academics at the University of Chicago and practitioners such as John Bogle of Vanguard, there began a trend toward index funds, with their low costs and assured inability to underperform…”
“With every period in which active managers underperformed, the trend toward indexing got another boost. The percentage of equities held via index funds rose…But as the groups most heavily represented in the S&P did best, indexation was in fact looked at as an offensive weapon…
By the end of 1999, technology stocks constituted roughly 40% of the S&P, and thus it no longer delivered ‘unbiased’ participation in equities…”
The Bottom Line
Low-cost index investing is undeniably a good thing for investors, but investors in market capitalization indices should be aware of these implicit bets in their portfolio and determine whether it is appropriate given their investment goals and objects. Equal weighted indices can offer a similarly low-cost option to those look for alternatives to market-capitalization weighted indices.