As big-cap tech approaches new highs, some put more emphasis on equal weight. It’s not clear that is the right bet. Almost half of the largest technology stocks are now at or less than 1% from a 52-week high, including Microsoft, Nvidia, Salesforce, Broadcom, Meta, Oracle, Lam Research, Applied Materials and Alphabet. Apple is 2% from a new high. The top 10 stocks in the S & P 500 now account for 30% of the entire market weight in the index, the highest in decades. To reduce concentration risk, some in the investing community who were long ago converted to indexing with market capitalization-weighted indexes are urging investors to instead take a look at owning indexes that equal-weight the S & P and other popular indexes. With more than $7 trillion indexed to the S & P 500, this is not an academic debate. “There’s plenty of consternation over the contribution of the five to 10 largest stocks to YTD performance, and while that’s what large weights in cap-weight indices are supposed to do, we’d rather not see them diverge further from the ‘average’ stock,” Todd Sohn from Strategas wrote in a recent note to clients. The ‘average’ stock has gone nowhere this year And yet, the “average” stock has indeed diverged from the index. But not in a good way. With the S & P 500 up 8% this year, the average stock, as represented by the S & P Equal Weight ETF (RSP), is up a measly 0.5%. The RSP has underperformed the market-cap weighted S & P 500 month-to-date, quarter-to-date, and year-to-date. That is an unusually wide divergence. Predictably, this has led to a lot of hand-wringing that there is something terribly wrong with the market. The argument for equal weighting The argument for equal weighting is based in simple history. Over the 20-year history of the RSP, it has outperformed the market cap-weighted S & P on a pure price basis (not including fees): Equal-weight vs. market cap weight (past 20 years) S & P 500 (equal-weighted): +425% S & P 500 (market cap weighted): +340% There’s several reasons equal weight has outperformed during this period. First, academic research indicates that over long periods of time (decades) there is a modest outperformance from smaller stocks over larger stocks, and from value stocks over growth stocks. An equal-weighted index would tilt toward both of those factors. Take small- and midsize stocks. By definition, equal-weight allows those stocks to have an equal influence with larger stocks. “By allocating equally to S & P 500 constituents [at] each quarter rebalance, the current index is less sensitive to the performance of the larger names in the market,” Hamish Preston, director of U.S. equity indices for S & P Dow Jones Indices, said in a recent presentation. Preston said that about 50% of the variation in returns could be attributable to smaller size. Another factor in the long-term outperformance comes from what Preston calls the “anti-momentum” effect: the equal weight index rebalances on a quarterly basis, so it sells shares of companies that have increased in value, and buys shares that have decreased in value. This is essentially a “value” play. Finally there is sector exposure. Tech stocks, which had an outsized market weight during the dot-com boom of the late 1990s, collapsed for a good part of the early 2000s, which led to an underperformance for the market-cap weighted S & P. Last year, low market-cap sectors like energy companies outperformed while large market-cap sectors like technology underperformed, and the equal-weight of course did better. This year, that has reversed. A benchmark for equal weight managers? It’s been known for decades that active managers underperform their benchmarks when measured over longer periods. An argument could be made that active managers invest more like an equal-weight index. “There’s plenty of research that indicates that active managers have a portfolio construction that is closer to equal-weighted than cap-weighted, and so equal-weighted may be a more appropriate benchmark for many,” Preston said. For example, in the S & P Technology Index, three stocks are 50% of that index. In the Consumer Discretionary Index, the top 3 names account for nearly 45%. An “investor who wants to get exposure to the economics of the sector, and invest for the developments in that sector, are going to be better off at equal-weighting that sector, because they are going to have more broad exposure to the companies in that sector,” Preston said. Unfortunately, shifting the bogey does not improve the performance of active managers. Beating benchmarks of any type is difficult, Preston said. He noted that over the 20-year period ending in June of 2022, 95% of large-cap managers underperform the S & P 500, and 99% underperformed the equal-weight S & P. Equal-weight has an uphill battle 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. While that view — “let the market decide who the winners and losers should be” — is still the dominant mode of thinking, supporters of equal-weight indexing point out that a small but growing minority of the investing public is more concerned about safety than outperformance. “I think there’s evidence that the winner-take-all nature of modern capitalism is accelerating, not decelerating, which makes the case for equal weight really about safety, not outperformance,” Dave Nadig, a “financial futurist” at VettaFi, said in an email.
This story originally appeared on CNBC
