Indices: Market Cap Or Equal Weighted?

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Includes: RSP, SPY
by: Lynx Investment Advisory

Summary

A significant difference between an S&P 500 market cap vs. equal weighted index is tech company exposure.

Company size plays a part in the performance differential between market cap and equal weighted indices.

Historical context helps to better predict which approach may outperform in the future.

It is no secret that active managers have been getting a bit of a beating lately as many alpha driven portfolio managers have considerably underperformed their respective indices in recent years. In response to their shortfall, the industry has seen a shift in interest from alpha to beta and now to smart beta. The question then becomes, what does this mean? Is this sustainable? Will this apparent indifference to fundamentals continue? If the answer is yes and if investors remain invested in beta strategies, the next reasonable question might be, are all index funds created equal? The answer of course is no, for a variety of reasons: market selected, fees, fund liquidity, leverage, exposure, etc. For purposes of this paper, let's focus on the U.S. market, and more specifically, exclusively discuss the S&P 500 index. For those index funds focused solely on the S&P 500 market, there exist two different investment approaches: The first is market weighted, while the second is a fund designed to equally weight exposures. An index that is market cap weighted would have the largest underlying company's stock as its highest allocation, which in the case of the S&P 500, is Apple at 3.9% of the index. An index that is equally weighted weights each underlying holding equally, with no preference to a company's size. In this case, the equally weighted index holds Apple stock at a 0.22% weight. Table 1 provides the difference by sector between the two investment strategies. As is evident, while there are considerable differences in the weights across all sectors, the most glaring difference is in the technology sector, 23.32% versus 14.40%.

Table 1

Let's explore the weights of the so-called FANG (Facebook, Amazon, Netflix and Google) stocks. Table 2 provides the weights of the FANG stocks for a both a market cap and equally weighted index. For the market cap weighted index these stocks account for 6.79%, while the equal weighted index holds them at 0.80%.

Table 2

As you can imagine, performance will vary considerable depending on the index approach. Table 3 puts this discussion into historical context. During the 1990s, the market weighted index outperformed the equal weighted index, while the following decade equal weighted outperformed and finally, from 2010 through last month, equal weight outperformed but not by as wide of a margin. It is not surprising market cap weighted outperformed in the 1990s given the strength of technology stocks, which was then followed by a sharp reversal in the sector in the early 2000s, leading to superior performance from an equally weighted index. The question of the moment is, how will the rest of this decade play out? The answer lies in an investor's expectations for technology stocks, since they are the biggest difference in the two indices. Also, important to consider is which company size, large or mid and small, will outperform. If the bias is towards small and mid, an equally weighted index might make more sense given that they tend to have a higher allocation to companies on mid and smaller side. Will this trend continue? It's hard to predict with any certainty, but what is important to keep in mind when investing in an equally weighted benchmark is transaction costs and possible increased taxable gains (if you are a taxable investor) driven by the higher degree of rebalancing required to keep the portfolio correctly weighted. Also, be aware that the mandatory rebalancing tends to lead to a higher expense ratio. Conversely, rebalancing mitigates performance chasing and inefficiencies that tend to occur in the cap weighted index.

Table 3

As we've outlined, there are positives and negatives to each approach, as well as periods of outperformance of one strategy over the other. As previously mentioned, market cap weighted tends to lead to inefficiencies and the need to use other indexes to help balance exposures, while equal weighted has automatic rebalancing and mitigates performance chasing, typically at the expense of a higher turnover and fund fees. We believe, an advantaged way to capture the S&P 500 market weighted index is through the ETF SPY, while the ETF RSP is ideal for obtaining equal weighted exposure.

Disclosure: I am/we are long SPY.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.