The S&P 500 Equal Weight index doesn’t always outperform, as demonstrated by its lagging this year despite handily outpaced its parent cap-weight index in 2022.
Equal weight funds, such as the Invesco S&P 500® Equal Weight ETF (RSP), are best used as a long-term core holding despite not outperforming in every economic environment. However, it’s helpful for investors to understand when these strategies are positioned to outperform.
The methodology of selling relative winners and buying relative losers adds the small size and value factor tilts to a portfolio. Factor tilts are an important aspect to consider when assessing RSP’s strength in the current environment.
“Generally, equal weight is going to work well when the size and the value factors are doing well,” Nick Kalivas, head of factor and core equity product strategy for Invesco, told VettaFi. “That tends to be accelerating economic growth, falling risk — either falling equity volatility or falling credit spreads. It’s going to tend to lag in the opposite.”
See more: “Pair Equal Weight With Momentum to Generate Excess Returns”
Kalivas said when there is decelerating growth, there is rising risk and widening credit spreads. This kind of environment acts as a headwind for the size and value factors. Typically, when the market’s falling, equal weight will fall faster. Conversely, when the market is recovering, equal weight will rise quicker.
“It has a higher beta to it. A higher up capture, higher down capture by the nature of the size and the value factors,” Kalivas said.
Another Scenario for Equal Weight to Outperform
This is an exception to that rule, however. And that’s when the market is focused on valuation.
In the early 2000s, RSP outperformed because growth valuations were compressed. The big growth-y names saw their valuations compressed, which was a similar situation to what happened last year.
“Growth was decelerating, volatility was elevated last year, and equal weight outperformed. The reason was that the market adjusted the valuation of growth stocks down,” Kalivas said. “So the valuation compression dynamic, when it’s present, seems to favor equal weight.”
Kalivas said the current environment is an interesting situation as the top 50 names in the S&P have relatively high valuations compared to the rest of the market.
“One of the risks investors do face is that when they buy cap weighted, they’re kind of allocating more to those bigger names, and they are entering into higher valuations,” Kalivas said. “I think if you’re looking out a year, a couple years, really that’s where the benefit of have equal weight or size or value. You have more appreciation potential given the discounted nature of the valuation,” Kalivas added.
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