Avoiding concentration risk is one of the primary reasons that investors turn to equal-weight exchange traded funds, including the famed Invesco S&P 500 Equal Weight ETF (RSP).
Interestingly, elevated concentrations among individual components in cap-weighted indexes, such as the S&P 500, can be a signal of looming outperformance by equal-weight alternatives. Taking that notion a step further, some experts argue that there are comparable clues stemming from elevated sector level concentration — a condition the S&P 500 recently experienced with the technology sector.
“Using the historical adjusted HHI (Herfindahl-Hirschman Index), we’ve previously established that concentration tends to mean-revert in most sectors. Changes in concentration affect the relative performance of the equal-weighted versions of each sector,” notes Anu Ganti of S&P Dow Jones Indices. “Equal-weighted sectors tend to outperform after peaks in their sector concentration. This is particularly noticeable for Information Technology.”
For investors considering an equal-weight spin on technology stocks, the Invesco S&P 500 Equal Weight Tech ETF (RYT) is the ETF to evaluate. As Ganti notes, outperformance by smaller stocks often gives way to outperformance by equal-weight strategies.
“Changes in equal-weighted relative performance and changes in concentration are not two separate things, but two aspects of the same thing,” Ganti adds. “If larger stocks outperform smaller ones, concentration will increase, and equal weight will underperform. Similarly, if smaller stocks outperform, concentration will decrease, and equal weight will outperform.”
At the sector level, recent concentrations among consumer discretionary — largely thanks to Amazon (NASDAQ:AMZN) and Tesla (NASDAQ:TSLA) — and tech names exceed those of the cap-weighted S&P 500, with the other sectors sporting below-average concentration relative to the benchmark domestic equity gauge. The Invesco S&P 500 Equal Weight Consumer Discretionary ETF (RCD) is the equal-weight play on consumer cyclical stocks.
Energy, industrials, and materials are at historically low levels of concentration compared to the cap-weighted S&P 500. That could be a sign that cap-weighted ETFs addressing those sectors could be poised for more upside.
“Since Information Technology and Consumer Discretionary’s adjusted HHIs are at historically high levels, equal weighting within these sectors might be worth considering rather than cap weighting, since concentration tends to mean-revert over time,” concludes Ganti.
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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.