Equal-weight investing strategies for investing in stocks are often promoted as “smart beta” and a way to diversify, but is that really the case?
There are exchange-traded funds (ETFs) that equal weight the S&P 500 Index, for example. Rather than weighting stocks by their size (market capitalization), these strategies simply allocate an even amount to every stock and rebalance periodically to maintain the equal weighting.
Therefore, in the case of the S&P 500 Index, each stock gets a 0.2% target weighting. This does prevent concentration in the index’s largest names, which is why equal weighting the S&P 500 Index is sometimes promoted as a more diversified approach than traditional market cap weighting.
However, investors may simply end up with a tilt to the smaller companies in the S&P 500 Index, or a mid-cap approach at times. For example, the average market cap of a holding in the largest ETF following the equal-weight S&P 500 Index is $26.1 billion, compared with $84.4 billion for the Russell 1000 Index, a common benchmark of U.S. large-cap stocks.¹ Equal weighting may also result in potentially higher fees, turnover, and taxes than cap-weighted approaches.
Viewed through the lens of factor investing, there are some other consequences of equal weighting the S&P 500 Index. There may be an underweight in the quality factor relative to the cap-weighted index, possibly resulting from an underweight in the technology sector. More technology firms are scoring higher on the quality factor due to their steady profits and solid balance sheets. Companies with higher quality and profitability have historically outperformed lower-quality stocks, according to academic research.
Also from a factor perspective, equal weighting tends to result in an underweight in the momentum factor. This is due to rebalancing to get back to equal weighting. Trimming exposure to winning stocks and adding exposure to losing stocks typically results in an underweight in momentum stocks, or those that have seen their prices rise quickly the past year.
Performance and volatility
We don’t believe there’s anything special about equal weighting. To us, it simply provides more exposure to smaller stocks, which academic research has shown to outperform large caps over long periods.
Yet, investors should keep in mind that smaller stocks tend to be more volatile than bigger, more established companies. That means equal-weight strategies may fall more than market-cap-weighted approaches during recessions and market downturns. In a nutshell, equal weighting may result in a higher beta, or more sensitivity to moves in the overall market.
The S&P 500 Equal Weight Index had a 10-year annualized total return of 14.0%, compared with 13.7% for the S&P 500 Index.² The equal-weight index had more volatility over the same period with a standard deviation of 13.7%, compared with 12.5% for the cap-weighted S&P 500.² Again, this shouldn’t be a revelation for factor investors, since equal weighting results in a tilt to smaller companies, which have historically outperformed, but with more volatility.
It should also be noted that the longer-term performance data for an equal-weight S&P 500, versus the cap-weighted index, may be driven by a big outperformance year for U.S. mid-cap stocks in 2009 during the initial rebound from the global financial crisis. Remember, an equal-weighted S&P 500 tends to have a mid-cap bias relative to the cap-weighted version. The S&P MidCap 400 Index surged 37.4% in 2009 on a total-return basis, easily outpacing the 26.5% return for the S&P 500 that year.²
Turnover and sector biases
Equal-weight indexes frequently rebalance, such as on a quarterly basis, to maintain their equal weighting. This typically results in higher turnover than market-cap-weighted indexes. It also results in an “anti-momentum” factor bias, as mentioned above.
Equal-weight indexes may also favor particular sectors relative to market cap weighting. Remember, the sector weightings of an equal-weight S&P 500 Index are simply determined by the number of stocks selected from any sector. One result is that the equal-weighted version of the benchmark has less exposure to the technology sector.
Putting it all together, the idea of equal-weight strategies may make intuitive sense for diversification. But in reality, investors may be left with an approach that results in higher volatility due to the bias to smaller stocks, higher turnover, and potential unintended sector tilts.
1 Morningstar data, as of 9/25/19. 2 S&P Dow Jones Indices, as of 10/31/19.