Equal Weight S&P 500 ETF Doubles Market Weight's 8 Year Returns

by: George Fisher
Two old friends and investors met at the local tavern. After consuming a few beers, they started to discuss the markets, with one quipping, “My S&P 500 Index fund has done just so-so over the past few years and is up about 45% since 2003.” To which, the other replies, “My S&P 500 Index fund has doubled since 2003.” “No it hasn’t. How can that be? You must be drinking too much.” “Yes it has. And, yes, I may be partaking a bit too much these days. But, believe me, my S&P 500 Index fund has doubled in eight years while the S&P 500 Index is up just shy of half.”
How can that be? The answer is simple –a capitalization or market weight index vs. an equal weight index of the exact same stocks.
Many investors own SPY, the original S&P 500 Index ETF fund, or a similar mutual fund or ETF, and its portfolio is designed to match the S&P 500 Index, which is a capitalization weighted index. The S&P 500 Index is weighted by the market capitalization of each stock in the index. In such a weighting scheme, larger companies account for a greater portion of the index and the larger the capitalization, the more impact their performance will have on the value of the index. The index will represent a relatively small number of very large companies with commensurate large overweighting. Most indexes are constructed in this manner.
As of July 20,2011, the top capitalized stocks and their weighting in the S&P 500 were:
Exxon Mobile (NYSE:XOM) 3.41 %
Apple (OTC:APPL) 2.92%
IBM (NYSE:IBM) 1.83%
Chevron (NYSE:CVX) 1.79%
General Electric (NYSE:GE) 1.66%
Microsoft (NASDAQ:MSFT) 1.64%
Johnson & Johnson (NYSE:JNJ) 1.48%
Proctor & Gamble (NYSE:PG) 1.47%
AT&T (NYSE:T) 1.46%
JP Morgan Chase (NYSE:JPM) 1.37%
The largest 10 companies out of 500 represent 19.03% of the value of the entire index. The smallest 10 companies represent just 0.14% of the index.
In 2003, the Equal Weight S&P 500 Index (NYSEARCA:RSP) was developed. The concept is to maintain a 0.02% equal representation from each of the 500 companies and readjust the portfolio periodically to reflect an equal weighting. ExxonMobil and Apple combined equal 6.33% of the market weight index versus 0.04% of the equal weight index. RSP, the Rydex S&P 500 ETF, holds the same stock names and replicates the equal weight S&P 500 Index. RSP incorporates as much of the largest companies as it does the smallest.
The sectors that make up the index also vary with the performance of the underlying stocks. As of July 20, the sector make-up of the S&P 500 market weight index versus equal weight index were:
Technology 17.8% vs 14.9%
Financial 15.1% vs 16.2%
Energy 12.7% vs 8.6%
Healthcare 11.7% vs 10.3%
Industrials 11.3% vs 10.1%
Consumer Discretionary 10.6% vs 15.8%
Consumer Staples 10.6% vs 8.8%
Materials 3.7% vs 6.1%
Utilities 3.4% vs 6.4%
Telecom 3.1% vs 1.6%
The market weight index is overweighted in Tech, Financials and Energy while underweighted Materials, Utilities, and Telecom. The equal weight index is overweighted in Technology, Financials, and Consumer Discretionary sectors while slightly underweight in the same sectors.
Thus, when compared with a market weight index, the equal weight index will always have a greater exposure to smaller market cap stocks and less exposure to large-cap stocks. In addition, the sectors should be more evenly represented with an equal weight index.
In times when small- and mid-cap companies outperform their large-cap brethren, the equal weight index should outperform as well. This has been the case over the past two years. Small and mid caps usually do better during early- and mid-cycle growth and worse during late cycles and contractions.
The choice for equal weighted ETF is growing. An equal weight Nasdaq 100 ETF was formed in 2006 (NASDAQ:QQEW), and it too has slightly outperformed the Nasdaq 100 since early 2009. Last December, Rydex launched several new equal weight sector ETFs: Energy (NYSEARCA:RYE), Technology (NYSEARCA:RYT), and Basic Materials (RYM). In addition, the Rydex family of equal weighted ETF also include the Russell 1000 (EWRI), Russell 2000 (EWRS), Russell Mid-Cap (EWRM), along with two international funds (EWEF and EWEM).
Reviewing the following charts will show there have been times of equal, better and worse performance of the equal weight index. RSP outperformed SPY from 2003 to mid-2007, then by early-2009 gave it all back in the market malaise, and has outperformed since. RSP is currently approaching its highs of mid-2007.
From the time of its inception eight years ago, RSP has gained about 100% versus 45% for SPY. Equal weighting has performed well: the Rydex S&P 500 Equal Weight ETF has beaten the S&P 500 over the recent one-, three- and four-year periods.
(Click charts to enlarge)
8-year chart RSP vs. SPY:

4-year chart RSP vs. SPY:

3-year chart RSP vs SPY:

1-year chart RSP vs SPY:
This eight-year period incorporates two expansions and one severe downturn. If the US economy continues to expand over the next few years and large caps continue to be laggards, RSP should maintain its outperformance. However, if the economic cycle is petering out, and as small- and mid-cap stocks are usually more vulnerable in times of market and overall economic weakness, it could be prudent to think about switching from RSP to SPY for better downside protection.

As always, investors should conduct their own due diligence, should develop their own understanding of these potential opportunities, and should determine how it may fit their current financial situation.

Disclosure: I am long RSP.