The Equal-Weight Index: Upside And Downside

The S&P 500, as well as most of mutual funds and ETFs that track the benchmark, is a market-cap weighted index. This means the weights of the index’s components are determined based on their market capitals. The larger a company’s market value, the heavier the weight in the index.

As a result, according to IndexArb.com, the largest 20 companies in the S&P 500, including mega-cap companies such as ExxonMobil (XOM), GE (GE), Citigroup (C), Microsoft (MSFT), AT&T (T) and Bank of America (BAC), etc., contribute to more than 30% of the index (only floating shares are used in calculating the weights in September 2005). Currently, large-cap stocks make up nearly 90% of the index, while the reset are mid-cap stocks. The smallest components, Circuit City (CC) and Dillard’s (DDS), have only $1.8B in market capital.

Another way to construct the index is, instead of assigning weights according to the stock’s market capital, to give each component the identical weight, thus the equal-weight index. For the S&P 500, since big companies carry much more weights than smaller ones, any dramatic price change of the big names will have a significant impact on the index, though the number of companies involved could be very small.

On the other hand, the same change will have a limited impact an equal-weight index as every member shares the same level of responsibility for the index’s movement. Another benefit is, as small- and mid-cap stocks performed historically better than their large-cap counterparts, an equal-weight S&P index could outperform the market-cap weight index in the long term.

Rydex S&P Equal Weight (RSP) is an exchange traded fund [ETF] built based on this equal-weight theory. The following is a chart comparing RSP and the S&P 500 in the past 2 years. According to Morningstar, the 3-year annualized return of RSP is nearly 2% higher than S&P.

In addition, the principle of buy-low-and-sell-high can be well applied to funds tracking an equal-weight index. For example, if a company grows out of proportion, then the fund manager will have to sell shares of the company at highs to maintain the assigned weight. For a member company that’s losing market value, more shares will be purchased when the price is low to keep the allocation. For funds that track the S&P, the opposite will happen.

Then what’s the downside of the equal-weight index? The following is a 1-month chart of RSP and the S&P for the past month. From July 19th to August 15th, the S&P was down 9.47%, but RSP lost 11.05% due to the fund’s 43% share in mid-cap stocks. Looking at the same period, the S&P 400 mid-cap index declined 11.26% while the Russell 2000 small-cap index dropped 11.75%.

Also an equal-weight portfolio should be rebalanced periodically, resulting higher turnover ration. This can be seen from RSP’s 15% annual turnover ratio as compared to SPDRs’ (SPY) 4%.