There is a lot of merit in the traditional capital-weighted S&P500, but it also comes with risks as it is heavily skewed towards today’s winner. Could the equal-weighted S&P500 offer a broader diversification, and continue to outpace the capital-weighted S&P500?
Investing in the main US benchmark, the S&P500, has been the “standard” to gain exposure to the leading American companies. However, over time, the market-cap weighted index has grown into a concentrated fund by individual names and sectors, not reflecting the fact that it has exposure to a total of 500 companies. On top of that, recent and long-term historical performance may reveal that the more diversified equal-weight index helps investors avoid market pitfalls and achieve higher performances, passively.
In January 2003, S&P Global launched the S&P500 Equal Weight Index, leading the way for the development of non-market-cap weighted indices.
Over the last 20 years, equal-weight S&P500 outperformed the traditional capital-weighted S&P500 by about 2% annually. One study even showed that over the full 90 years, it outperformed capitalization-weighted by 2.7% a year.
Over the past 6 months, the equal weight S&P500 has outperformed the capital-weighted S&P500 by approximately 3.5%. The outperformance was boosted as the popular ‘growth’ stocks, which make a large portion of the capital-weight S&P500 with the mega-cap tech stocks, fell the most. Defensives and value stocks fared better, leading to sharp outperformance of the more diversified S&P500 across sectors and styles (value and growth).
Avoiding momentum bias & market timing
Will today’s stock market darlings really be tomorrow’s leading stocks?
Investors are attracted to invest in the latest trends. Markets often misprice certain parts of the market, leading to some stocks outperforming the rest of the market over the medium-term, before reverting to their mean valuations. In the latest example, high-growth technology stocks saw their valuations expand significantly during the pandemic market boom that began in the spring of 2020.
As lockdowns and work from home diminished and the era of extremely accommodative fiscal and monetary policies ended, technology stocks underperformed the rest of the market and reversed to their mean valuation multiples. Oil & gas which was heavily penalized during the pandemic and disliked by investors who rushed to invest in ESG funds saw a massive rally in 2021 and 2022.
These massive differentials in sectorial performance tell us that it is difficult to predict if today’s winners will be tomorrow’s winners, timing the market is difficult, and sector diversification is an investor’s seatbelt to navigate volatile market cycles.
Today, Information Technology, and Health Care are at peak concentration.
In that case, maybe the high exposure to IT and Health Care in the traditional S&P500 could not be worth the added risk. The equal-weight S&P500 offers a balanced method to gain exposure to all names and sectors more equally, which could be the key to avoiding pockets of overvalued parts of the market.
Broader diversification tends to win during market sell-offs as certain events may reveal pitfalls in individual names for example. Throughout history, times of peak S&P500 concentration has tended to see the equal-weight S&P500 perform better than its concentrated peer. Similarly, the least represented sectors in the S&P500 tend to be under-owned by investors, and perhaps underappreciated, which positions those assets to potentially outperform the rest of the market in the years following peak concentration.
Here is a look at PE multiples for both equal-weighted and capital-weighted S&P500 Indices.
The traditional S&P500, which demands higher valuation multiples, may have more expectations from investors (higher growth and quality earnings), which can also make it vulnerable during episodes of market stress, even if these are short-term.
Other elements to consider
According to S&P Global analysis, by deviating from market-cap weighting, an equal-weight index generally displays a small-cap bias, value tilt, and higher portfolio volatility than a broad market-cap-weighted index. As examples, Apple and Microsoft, which represents a large portion of the capital-weighted S&P500 Index, trade with low volatility, thanks to their USD 2 trillion-plus market capitalization.
All things considered, the added value of a more diversified index tends to provide more stable returns, and thus are a positive for investors to stay the course amid the volatility during market cycles, as opposed to being tempted to trim their portfolios during adverse market events.
The equal-weight S&P500 Index is another element in the toolbox for investors to manage their overall portfolio risk. While some investors may prefer the natural selection of capital-weighted indices in which the most successful firms become the largest, market elements also lead to some companies growing their market cap faster than their business. Throughout history, the equal-weighted S&P500 has proved to be a net contributor to performance, and, most importantly, it is more diversified, thus investors may consider it as a ‘tool’ in building their portfolios. Lastly, investors should consider that the equal-weight index may outperform particularly at times when cyclical stocks do well due to its value-tilt.