Not all funds that track the same index are created equal. For some, inequality is part of the design. Take the S&P 500 (.SPX) and the S&P 500 SPDR E.T.F. (SPY).
Apple (AAPL) is the S&P 500’s largest constituent, 4.7 percent in early January. News Corporation, the smallest member, accounted for less than 0.01 percent of the index.
That’s because the S&P 500, like many other major indexes, are “capitalization weighted,” meaning that each company’s value, or market capitalization, determines how much weight it has in the index. The idea is to get a faithful representation of the stock market by giving each individual stock its appropriate relative value.
But that’s not the only way to build an index.
One alternative is to maintain roughly the same allocation to every company. An equal-weighted version of the S&P 500, for example, will adjust its holdings periodically to ensure that Apple, News Corporation and everything in between makes up just 0.2 percent of the portfolio. The Invesco S&P 500 Equal Weight E.T.F. (EWCO) does that.
Like a lot of things in investing, there are merits to both methods. Over some very long periods, equal-weighted funds have beaten equivalent capitalization-weighted funds, but over the last few years, the latter have outperformed.
“The equal-weight approach” involves “making sure exposure remains diversified,” said Todd Rosenbluth, director of E.T.F. research at CFRA Research. If Apple, the biggest stock in the S&P 500, soars, it will give a big lift to the traditionally composed index. In an equal-weighted version, though, Apple will provide a more muted benefit. “The downside is that winners can continue to climb higher, and we’re certainly seeing that this time around,” Mr. Rosenbluth said.
Beyond greater diversification, proponents say, equal weighting benefits from a greater emphasis on stocks of smaller companies and ones in more economically sensitive, so-called value, industries.
And because equal-weighted portfolios must be rebalanced periodically, it is an inherently contrarian strategy, forcing investors to “trim what is newly beloved and buy what is hated,” said Rob Arnott, chairman of the investment advisory service Research Affiliates.
Invesco S&P 500 Equal Weight is rebalanced quarterly. A competitor, Goldman Sachs Equal Weight U.S. Large-Cap Equity E.T.F. (GSEW), which tracks an index that is nearly — but not exactly — identical to the S&P 500, is rebalanced monthly.
Despite the arguments for equal weighting, the strategy remains an acquired taste that comparatively few investors have acquired.
The Invesco E.T.F. had $16.8 billion in assets at the end of 2019, according to Morningstar, and Invesco’s equal-weighted S&P 500 mutual fund had less than half that much. Those totals were dwarfed by the $307.4 billion in the S&P 500 SPDR. Proportions were similarly lopsided for other equal-weighted E.T.F.s and their capitalization-weighted equivalents.
The case for equal weighting may seem harder to make these days, as the market has behaved in ways that have all but eliminated its advantages. Big stocks have handily beaten small ones for the last year or so, for instance.
For longer than that, investors facing a chronically lackluster economy have relentlessly bid up sectors that maintain or expand earnings in times of sluggish growth, such as consumer staples, utilities and technology. At the same time, they have shunned those in value sectors like energy and materials. For equal weighting to excel again may require investors to become fickle again.
“What happens in equal weighting is everything starts out equal, and at the next rebalancing you’re going to sell winners and buy more of the losers,” said Elisabeth Kashner, director of E.T.F. research at FactSet Research. “That’s a winning proposition where everything regresses to the mean. It’s a losing proposition in a momentum market where winners keep winning and losers keep losing.”
Over longer periods, equal-weighted funds have excelled. Since its inception in 2003, the Invesco S&P 500 Equal Weight has had an annualized return of 11.2 percent, compared with 10 percent for the capitalization-weighted S&P 500 SPDR, according to Morningstar.
Over one, three and five years, however, the SPDR E.T.F. has outperformed by at least two percentage points a year.
The Goldman Sachs E.T.F., since its introduction late in 2017, has beaten the Invesco fund slightly, but both funds lag the SPDR.
Ms. Kashner cited an added cost for equal-weighted funds: greater risk. Invesco S&P 500 Equal Weight has traded over its lifetime with 61 percent more volatility than the SPDR, she said.
“You can look at past returns and make statements about performance,” Ms. Kashner said. “What’s more useful is to understand the bets you’re making when you go into something equal weighted. I don’t think there’s a better or worse option.”
The added diversification of equal-weighted funds and the prospect of a reversal of the momentum-driven nature of the current market lead some investment advisers to prefer them.
“An equal-weight fund avoids the risk of a company that blows up when it’s materially overweight in an index,” said Dan Weiskopf, a strategist for the E.T.F. Think Tank, a website that provides information about E.T.F.s to financial advisers.
That risk is higher when a fund focuses on a sector rather than the whole market. The performance of S&P 500 Consumer Discretionary Select Sector SPDR (XLY), for example, is largely at the mercy of Amazon (AMZN), which accounted for 24.2 percent of its portfolio in early January. Home Depot (HD), a distant yet hefty second, made up about 10 percent.
Mr. Rosenbluth also favors the strategy, recommending the Goldman Sachs equal-weighted E.T.F., the Invesco one covering the S&P 500 and the Direxion Nasdaq 100 Equal-Weighted E.T.F. (QQQE) He also likes the SPDR equal-weighted sector E.T.F.s. But he acknowledged some reservations.
Equal-weighted funds tend to be “more expensive, smaller in size and trade less frequently than the cap-weighted alternatives,” he said. The diversification they provide outweighs those drawbacks, in his view, “but they are things for investors to keep in mind.”
|For more news you can use to help guide your financial life, visit our Insights page.|