Equal weighting, or assigning all stocks in an index the same weight, is one of the oldest alternatives to weighting stocks by market capitalization. It might also still be one of the best alternatives.
Regarding track record, the Invesco S&P 500 Equal Weight ETF (RSP) has that. The $31.58 billion exchange traded fund turns 19 years old next April. In other words, RSP has been through a variety of market climates and boom-and-bust cycles. Along the way, the king of equal-weight ETFs developed a reputation for outperforming the S&P 500. Diversification is key to that legacy.
“In a market-cap-weighted strategy, you end up owning more of the larger stocks because they have a greater weight in the index. In an equal weight strategy, you diversify it across a broader range of securities and sectors within the index,” according to Morningstar.
As history indicates, there are times when cap-weighted indexes sporting excessive allocations to a small number of stocks present risks and potential vulnerabilities to investors.
“In certain market conditions or market environments, the concentration of stocks into one sector that is performing really well benefits a market-cap-weighted strategy,” adds Morningstar. “It benefits when the market is going up, but then you also are impacted negatively on the downside. In an equal weight strategy, where you have a much smaller weight to a single stock exposure, your performance (positive or negative) isn’t as impacted by that single stock as you would have been in the market-cap-weighted strategy.”
The math is simple. Today, Apple (NASDAQ:AAPL) alone represents 6.82% of the cap-weighted S&P 500. That’s fine as long as that stock is going up, but it also implies that a supposedly diverse index isn’t really all that diverse. Conversely, the top 10 holdings in RSP combine for barely more than 2.2% of the fund’s weight.
Another point in favor of equal weighting is that the strategy’s drawbacks are minimal and don’t drag on long-term performance, as highlighted by RSP’s impressive track record.
“An equal-weight benchmark offers investors the dual benefit of reduced concentration risk and increased exposure to smaller stocks,” concludes Morningstar. “There are a few drawbacks. You do end up having slightly higher turnover in the portfolio. It’s not significant, but more than the traditional market-cap-weighted strategy. And the fund with the equal weight-strategy will underperform the index when certain stocks are galloping ahead. Though over the long run, it should even out.”
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The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.