The S&P 500 Morphs Into A Mid-Cap Value ETF

|
About: Reverse Cap Weighted U.S. Large Cap ETF (RVRS), Includes: RSP, SPY
by: George Fisher
Summary

Different weightings of the same stocks produce very different results.

The S&P 500 components can be fashioned into a Large-Cap Blend portfolio, a Multi-Cap Blend portfolio, or a Mid-Cap Value portfolio, based on how assets are assembled.

Not surprisingly, the sponsor of a new S&P 500 Index portfolio claims outperformance based on 10-yr back-testing.

Just when you thought it was safe to go back in the water, here comes reverse weighting ETFs. One reason many investors own an ETF is their ability to create a diversified, but quite focused, investment portfolio. These portfolios can be restricted to certain sectors and industries, to specific investment strategies, or to specific indexes. Some ETFs incorporate sectors, indexes and strategies. With an ever expanding thrust for "passive" investing options with a flair for a bit of "active" management, portfolio weighted options for index investors offer an intriguing twist on the old favorite - the S&P 500.

The S&P 500 Index is a list of the top 500 companies in the US. Determined by the S&P Dow Jones Indices firm, the index creates portfolio diversity among its unique weighting methodology. It is one of the most commonly followed equity indices and captures approximately 80% coverage of available market capitalization.

Originally identified as the Composite Index in 1923, since its development in 1957, the 500 Index is selected by committee, not a usually rules-based selection process like the various Russell Indexes. The Index is also known for its market-capitalization weighting. Prior to ETFs, mutual fund companies began offering funds focused on the Index, with Vanguard initiating the trend in 1976. The most popular ETF recreating the market-cap portfolio is the SPDR S&P 500 Index ETF (NYSEARCA:SPY), formed in 1993. SPY is the granddaddy of Index ETFs with current assets under management of $291 billion.

As "the market index," the investment goal of buying SPY would be to match market returns through a diversified holding of its components as a replication of the Index. Makes sense. SPY is normally categorized as a Large-Cap Blend investment style where the majority of assets are large caps and represent a combination of value and growth fundamentals. But what if an investor is seeking "above market" returns using the same stocks?

A strong attribute of the components of the S&P 500 Index is the list includes most of the top US companies - top in revenues, top in profits, top in their sector, etc. Using the same list of stocks as an initial screen, there have been some shuffling of each component's weighting to create different portfolios. One of my personal favorite is the broad-based equal-weighted S&P 500 ETF (NYSEARCA:RSP).

RSP uses the list of S&P stocks and owns all 500 stocks equally. Rather than the historic market capitalization weighted SPY, RSP rebalances quarterly, selling the quarterly winners and buying the quarterly laggards so that after rebalancing all components have the same investment value. Due to its more balanced capitalization portfolio across the list, RSP is usually grouped as either a Large-Cap Blend or a Multi-Cap Blend style.

Over the past 11 years, equal-weighted and rebalanced RSP has outperformed its market-weighted cousin SPY. The chart below shows the price-only returns for RSP vs. SPY from 5/1/2007 to 5/4/2018.

Morningstar offers the following comparison of trailing total returns for RSP vs. SPY:

Some could say it is only a 0.80% 10-yr annual outperformance. However, over that same 10 years, the total would represent 8.0% more money for the same dollar invested in SPY 10 years ago, and 17% more than the Large Blend mutual fund category average. During the last 15 years, an investment in RSP would have produced 22% more wealth than a comparable investment in SPY and 31% more than the category average. For the 3-yr and 5-yr trailing periods, RSP's performance has been below SPY and about average for the category.

The sector weightings of SPY jump around based on current sector popularity and performance. The table below outlines the sector weightings of the S&P 500 over time. As shown, at the beginning of 2000, technology comprised 31% of the weighting, and three years later it crumbled to 17% weighting. The same happened to financials from 2006 to 2009, falling from 22% to 12%. Note: In 2016, the S&P separated Finance and Real Estate sectors, and for comparison, these sectors were reunited in the table. In addition, the consumer sectors were combined as well.

A substantial difference between SPY and RSP is their respective sector weightings. While RSP is equal-weighted based on individual components, due to different numbers of companies per sector, the overall sector weighting is different than SPY, as outlined in the table below:

Just when investors thought the number of different configurations for the components of the S&P 500 Index were maxed out, enter the Reverse-Weighted Large Cap S&P 500 Index ETF (BATS:RVRS). Last Nov., Exponential ETFs introduced a novel strategy - owning the components of the Index in a weighting that is about reverse of the traditional index weighting. In other words, the top ten holdings of the cap-weighted Index become the bottom 10 holding in the reverse-weighted and vice versa.

From the factsheets offered on the ETF's website and eftdb.com:

The Reverse Cap Weighted U.S. Large Cap Index provides exposure to the companies in the S&P 500 index. However, while traditional market cap weighted indexes such as the S&P 500 weight companies inside the index by their relative market capitalization, the Reverse Index does the opposite, weighting companies by the inverse of their relative market cap. By investing smallest-to-biggest, the index is tilting investment exposure to the smaller end of the market cap spectrum within the large cap space.

Minding the Gap of Size Investing. Portfolios that allocate weightings by market capitalization skew to the largest stocks. This leaves large sections of the market under-represented or not represented at all. Reverse Cap weighting attempts to fill this gap by:

  • Lowering your portfolio's average market-cap exposure.
  • Providing more diversification with a less concentrated portfolio.
  • Avoiding the "buying high" bias by rebalancing based on current market capitalization every quarter.
  • The RVRS ETF can help bridge the gap between the investment exposure you think you have (large cap) and what you actually have (mega cap).

This strategy creates an interesting list of company exposure. Below are a few tables to contemplate. The first is a list of current industrial sector allocations compared to RSP and SPY, the most popular configurations of the Index. The second is a list of the top 20 holdings of RVRS.

Sector Weightings

Largest Portfolio Positions

The top holdings of the SPY become the bottom holdings of RVRS. True to its name, the portfolio contains only one share of: UnitedHealth Group, Inc. (NYSE:UNH), Berkshire Hathaway Inc. B (NYSE:BRK.B), Apple (NASDAQ:AAPL), Facebook (NASDAQ:FB), Johnson & Johnson (NYSE:JNJ), JPMorgan (NYSE:JPM) and Microsoft (NASDAQ:MSFT).

As the ETF's inception date is very recent, Nov. 2017, there are no meaningful investment performance numbers to compare. However, the ETF sponsor offers back-testing results in its presentation and a white paper found on its website.

The first graphic compares the back-tested 10-yr performance and risk profile of various component configurations of the S&P 500 Index. Of interest, and cynically should be expected, according to the ETF sponsor, the Reverse-Weighted portfolio outperformed all other configurations. However, investors should note the higher standard deviation of RVRS implies higher portfolio volatility. The second graphic describes the 10-yr growth in value of each of these various investment strategies. There are graphics for 3-yr and 5-yr back-testing on its website.

The white paper offers an interesting recap of possible justifications for owning the reverse-weighted ETF, and how its inclusion in portfolios is positive for investors.

The empirical superiority since the 2003 inception of equally-weighted RSP, over cap-weighted SPY, has demonstrated that nonmarket-cap weighted schemes using S&P 500 stocks now have the potential to succeed. These results provided the inspiration for the Reverse Cap Weighted U.S. Large Cap Index (REVERSE). If equal weighting resulted in superior returns by avoiding increasing allocations to increasingly overpriced stocks, perhaps reversing the allocation completely would result in even higher returns. Examining the literature and actual launches, we found a number of compelling arguments and rationales why pursuing such a scheme made sense.

Next, we ran an empirical test which showed that for the ten-year-period ending September 30, 2017, the Reverse Cap Weighted U.S. Large Cap Index delivered 292 basis points per annum superior performance to the S&P 500 index. Although these superior returns are associated with greater market volatility, concerns are mitigated by our Sortino ratio tests - demonstrating that a disproportionate amount of that excess volatility is attributable to higher upside returns. Also noteworthy are the pronounced cyclical differences between REVERSE and the S&P 500 in up markets as compared with sideways and down markets.

For hedge funds and other investors implementing a regime change strategy, REVERSE represents a potentially powerful tactical tool.

As one of our newsletter subscribers describe the ETF: The "smaller-cap stocks of the large-cap index" sounds like a "light heavyweight" boxer - strong enough to throw a good punch but big enough to take one. Interesting metaphor.

In my personal portfolio, 8 various ETFs comprise 21.5% of assets allocated as equities/capital gains (vs. equities/income) and 10.7% of the total equities allocation. RVRS may be an interesting addition to ETF investment strategies focused on wide moats, founder-run companies, revenue-weighted financials, equal-weighted indexes, and value.

Of interest to me is the impact of the reverse weighting on the portfolio's investment style. As described above, SPY is categorized as a Large-Cap Blend and RSP is categorized as either a Large-Cap or Multi-Cap Blend. I like the concept of investing in a diversified list of the smaller names in the S&P 500, and RVRS could be a vehicle to accomplish this goal. With the upside-down weighting, RVRS is categorized as a Mid-Cap Value strategy, and is more in tune with my personal investing style.

While not currently in my personal portfolio, it is on a very short list of new stock names I'm looking to add.

Disclosure: I am/we are long RSP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.