When it comes to the world of ETFs, where investments are primarily made against various stock indexes, market cap-weighted indexes dominate. A clear example is the SPDR S&P 500 ETF Trust, the world’s largest ETF, managing nearly $550 billion—almost ten times as much as the largest ETF that follows the equal-weighted S&P 500 index.
With this dominance of market cap-weighted indexes, it has become increasingly relevant to discuss the choice between these and equal-weighted indexes. Although the equal-weighted S&P 500 index may not receive as much attention as the traditional index, it offers unique advantages that make it worth considering for investors seeking diversification and balance in their portfolios.
The Historical Concentration Risk is at an All-Time High
The concentration risk in the S&P 500 index is higher than it has been in 50 years, with tech giants like Apple, Microsoft, Nvidia, and Amazon holding a disproportionately large share of the market cap. This creates a significant impact on the index’s daily returns, making index investors heavily exposed to these companies and the specific sectors they belong to.
Diversification Benefits
One of the most obvious benefits of an equal-weighted S&P 500 index is its higher level of diversification. In a market cap-weighted index like the traditional S&P 500, the index is dominated by a few large companies known as the “Magnificent 7.” The top ten companies in the S&P 500 index today make up over a third of the total market cap, with the three largest companies—Apple, Microsoft, and Nvidia—weighing nearly 20 percent.
In contrast, an equal-weighted index assigns equal weight to each company, regardless of size, meaning that each company has the same impact on the index’s total return. This lower concentration on a few large companies provides a better risk spread, allowing investors to achieve a more balanced exposure to different sectors and companies.
Sector and Company Size Differences
Since an equal-weighted index is not dominated by large companies, it tends to give a relative overweight to sectors that typically consist of smaller companies, such as real estate and industrials. The tech sector still dominates the equal-weighted index but with a slight margin over the industrial sector. Additionally, the index overweights smaller tech companies, which have the potential to become future giants.
Another significant difference between the indexes is the difference in the size of companies. In the S&P 500 Equal Weight Index, medium-sized companies make up the majority of the index, while large and mega-cap companies, including those in the “Magnificent 7,” represent only a third of the index. This is in stark contrast to the S&P 500 Index, where large companies make up 82 percent.
Historical Performance
Over the past ten years, the market cap-weighted S&P 500 index has outperformed the equal-weighted index in terms of returns, largely due to its exposure to the largest companies and a high proportion of tech and communication companies. However, looking at the returns over the past 15 to 20 years, the performance between the indexes is almost equivalent, with a marginal advantage for the S&P 500 Equal Weight Index.
The systematic rebalancing of an equal-weighted index through quarterly rebalancing, systematically selling stocks that have increased in value and buying those that have decreased, may contribute to this outperformance.
Conclusion
While an equal-weighted S&P 500 index offers several potential advantages, including better diversification, equivalent returns, and a more accurate market representation, it is important to note that it also comes with some drawbacks, such as higher trading costs due to frequent rebalancing.
For investors seeking a diversified and balanced portfolio, an equal-weighted S&P 500 index may be an alternative to the traditional market cap-weighted index. Several ETFs listed on Avanza’s savings platform invest in the equal-weighted S&P 500 Equal Weight index, offering investors a chance to tap into these unique benefits.
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