Battle of the indexes: Equal Weighted vs. Market Cap Weighted

image_pdfimage_print

The S&P 500 is one of the most quoted indexes in the world. It tracks the largest companies in the U.S. and has become one of the most popular indexes for not only stock market returns but also for comparing performance against (often referred to as a benchmark). It’s become so popular that people have made it a staple in a portfolios by buying an S&P 500 ETF or mutual fund.

While plenty of people follow the index, few people actually understand how it’s constructed. The S&P 500 is a market capitalization weighted index. Here’s a quick definition:

A type of market index whose individual components are weighted according to their market capitalization, so that larger components carry a larger percentage weighting. 

So what does this really mean? It means that as companies grow larger and larger (think Apple or Exxon) they comprise more and more of the S&P 500 index. Currently the top 10 holdings in the S&P comprise 18% of the index. This is led by Apple which makes up 3.6%. The higher that the top 10 or 20 holdings go in price, the bigger percentage of the S&P 500 they make up. So what’s the issue with that? These large companies tend to be some of the most mature biggest companies in the market today. Owning more and more of these companies may not be a bad thing depending on your investment objective. However if your goal is growing your capital, there may be a better way.

Enter in equal weighted style indicies. Instead of being price or market cap weighted these indicies are equal weighted in terms of allocation. For example, each stock in the S&P 500 might have a .2% allocation to the index. This allows the buyer of the equal weight index to have more exposure to growth companies.

While there are dozens of these type of ETFs in the market, the most popular one is the Guggenheim S&P 500 Equal Weight ETF (RSP). Below is a chart of the S&P 500 (SPY) vs. the RSP. You can see for yourself the difference in performance. The RSP is up 135% compared to that SPY which is up 105%. That’s a difference of 30%!

SPY v RSP

 

So what are the risks of investing in an index like the RSP? There are two main considerations for someone to think about.

  1. Volatility. The RSP has a beta of 1.10. This means that it is 10% more volatile than the overall market (S&P 500). It’s important to note that beta is a past calculation and it doesn’t mean that it will continue to be more volatile than the market, but if history is a guide the RSP does carry a little more up and down movement.
  2. Fees. Because the RSP (and other ETFs like it) are equal weight, it takes a lot more time to manage those active products. The RSP annual management fee is .40% compared to the SPY of .09%. These fees eat into the overall returns over time.

Whatever strategy you employ you must understand your goals, risk and probabilities. The RSP or an index like it may not be for everyone.

Successful investing.

image_pdfimage_print
Categories: Markets and Strategy.