What 20 years of equal-weighted indexes that try and improve on the S&P 500 show

Published Mon, May 1 20239:10 AM EDTUpdated Mon, May 1 202310:05 AM EDT

This is the 20th anniversary of the launch of the Invesco S & P 500 Equal Weight ETF (RSP). The index weighs all 500 stocks in the S & P 500 equally, as opposed to the S & P 500, the modern version of which was launched in 1957 as a market-cap weighted index. Under the traditional system, stocks that have a higher market capitalization (price multiplied by shares outstanding) have a higher weighting in the index. Equal-weighted indexes have been gaining adherents in the past few years because many believe the emphasis on market capitalization gives unfair weighting to technology and distorts the picture of the U.S. investing universe. Market cap weighting vs. equal weighting: which is better? The idea of equal-weighting an index was a radical idea when it was launched in 2003. It came out of the ashes of the dot.com disaster, where technology stocks dominated the major indexes, and when they crashed, they took the indexes down with them. The argument for an equal weighted index is that it is value-driven: an equal-weight index will buy more shares of a company declining in value, and sell those increasing in value. A market capitalization weighted index is essentially driven by momentum: those stocks that are rising in price have a bigger weighting in the index. This creates a concentration risk. For example, the top 10 stocks in the S & P 500 currently constitute about one-third of the value of the entire index. Investing in an equal-weight index reduces concentration risk. While value investing has many adherents, equal-weight indexes are still a distinct minority in the investing world. The reason: most investors believe that the public rightly votes on which stocks are winning and losing, and market capitalization is a better reflection of that voting. "Broad, market cap weighted indexes are the purest form of indexing," Ben Johnson, head of client solutions at Morningstar, told me. "They own nearly everything and let the market decide what it's all worth and what the right weights are. Everything else represents an active decision to do something different than owning the market and letting it do the heavy lifting." Which is better? Twenty years ago, before the triumph of indexing, this was largely an academic issue. Not anymore. With north of $7 trillion indexed to the S & P 500, and getting larger every year, there is an awful lot of passive money at stake. Invesco says that over the last 20 years, an investment in the RSP has outperformed the market cap weight S & P 500: Market cap weighted investing vs. equal-weighting (last 20 years) S & P 500 (SPY) + 553% Equal weight S & P 500 + 667% Source: Invesco What do you own when you own an equal-weight S & P 500? Johnson notes that in the case of equal weighting, what comes out in the wash is a portfolio with a small-to-midcap bias, which might do better (see Dot.com Crash) or worse (see the recent Mega-Cap Tech-Led Market) "than cap weighting, depending on the timeframe in question...In the case of equal-weighted S & P 500, from a risk and return perspective, it has looked an awful lot like a midcap portfolio." The bottom line: equal-weighted indexes are a different way of looking at the stock market. It has a distinct tilt toward value and small-to-midcap stocks. There are times when this strategy has outperformed, and times when it hasn't. Equal-weight is not the only alternative Robert Arnott, who has been studying indexing for decades and is the founder of Research Affiliates, an asset management firm, recently wrote a paper reiterating many of the issues with market capitalization: "Buying mainly frothy stocks with strong momentum and selling mainly tumbling stocks that are severely out of favor, creates an unhelpful buy-high and sell-low dynamic in a cap-weighted index." Arnott says that decades of research indicates that giving weight to fundamental measures, like a company's revenues and profitability, then fusing it with market capitalization, will produce outperformance over traditional market cap-weighted indexes. It's an intriguing idea, but it's not easy moving the dial on the inertia of market cap-weighted indexes.