How Equal Weighting Eliminates Concentration Risk

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Includes: FB
by: Invesco US

By Nick Kalivas, Senior Equity Product Strategist on Sep 5, 2018, in Exchange-Traded Funds

How equal weighting eliminates concentration risk

Facebook illustrates how a big company's big loss can dominate traditional benchmarks

There are 26 constituents in the S&P 500 Communication Services Select Sector Index, but only one was on the minds of investors in late July - Facebook (NASDAQ:FB). A disappointing earnings release on July 25 led to a 21.35% drop in the stock's price over the next five days.1 Because of Facebook's outsized presence in the index, that drop had a huge effect on overall returns.

The index fell 7.02% over the same time frame - and 66.11% of that loss was due to Facebook.1 Past performance isn't a guarantee of future results, but whenever one stock has such an outsized influence on an index, that's known as concentration risk. It's a common risk that's embedded into many indexes, but there are strategies built specifically to eliminate it.

Market-cap weighting can lead to concentration risk

The S&P 500 Communication Services Select Sector Index has a definite concentration in Facebook - the company represented 21.73% of the index on June 25, which is why the company's loss was so impactful.1 But why does the index hold so much of one company? Because its weightings are based on each company's market capitalization, and Facebook had the biggest market cap of all the companies in the index. Many traditional benchmark indexes, such as the S&P 500 Index and the S&P 500 sector-specific indexes, are weighted in this manner.

An alternative to market-cap weighting is equal weighting. If this index were reshuffled into an equal-weight structure, Facebook - just like each of the other holdings - would have a 3.85% weight in the index. If that were the case, Facebook's late July loss would have had much less of an impact on the overall index. The index would have fallen 3.23% from July 25 to July 30, with Facebook representing 25.41% of that loss.1

Market-cap weighting vs. equal weighting

Source: Bloomberg, L.P. For illustrative purposes only; subject to change. Securities shown are for educational purposes and are not buy or sell recommendations.

Examining the other side of the coin

It's important to note that there may be cases where a company's adversity can have a larger impact on an equal-weighted portfolio than on a market-cap-weighted portfolio. Twitter (NYSE:TWTR) is an example. From July 25 to July 30, as Facebook lost 21.35%, Twitter declined even more - by 29.04% (shown in the table below). But, because Twitter had only a 2.90% weight in the market-cap-weighted S&P 500 Communication Services Select Sector Index, its loss had a much smaller impact on the whole, representing 12.00% of the index's loss (illustrated in the gray columns below).

But what would happen if we gave an equal weight to each holding in the index? In this scenario (illustrated in the blue columns below), Twitter would have a higher weight (3.85%), and a higher impact (34.55% of the index's loss).

Examining the effect of Facebook's and Twitter's July losses

Comparing the actual results of the S&P 500 Communication Services Select Sector Index with a hypothetical index that gives equal weight to the same holdings.

Source: Bloomberg, L.P. For illustrative purposes only; subject to change. Past performance is not a guarantee of future results. Investments cannot be made directly into an index. Securities shown for educational purposes and are not buy or sell recommendations.

Key takeaway

Investors in market-cap-weighted indexes may not be quite as diversified as they think they are, due to concentration risk. Equal weighting is a potential solution. Learn more about Invesco's equal-weighted exchange-traded funds.

1 Source: Bloomberg, L.P.

Important information

Blog header image: Guitar photographer/Shutterstock.com

Investments focused in a particular sector, such as communications and information technology, are subject to greater risk, and are more greatly impacted by market volatility, than more diversified investments.

The S&P 500® Communication Services Index comprises those companies included in the S&P 500 Index that are classified as members of the GICS® communication services sector.

This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial advisor/financial consultant before making any investment decisions. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

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How equal weighting eliminates concentration risk by Invesco US