Although capitalization-weighted index funds are the industry standard, there are several advantages to equal-weighted index funds that make them worth a close look for adding to your portfolio.
The main advantage, simply, is that evidence suggests that the equal weighted ones generally produce superior returns.
But the reasons why are complex, and there are several specific advantages and disadvantages, so this article explores them in detail to help you pick which ones are right for you.
What are Equal Weighted Index Funds?
A stock market index tracks a certain set of publicly traded companies, and the vast majority of these indices are weighted in terms of market capitalization. The market capitalization of a company is the sum value of the price of all of its shares.
Just about any S&P 500 fund you invest in puts a greater percentage of its money into very large companies compared to smaller companies on the index. Apple has a 10x bigger market capitalization than American Express, for example, and so the S&P 500 invests 10x more heavily into Apple despite the fact that they are both members of the index.
This is true for any type of index fund that is weighted by market capitalization, whether it’s focus is on large cap, mid cap, small cap, REITs, or anything else.
In fact, although the S&P 500 consists of, as you might guess, about 500 companies, the top 10 holdings in the list make up well over 20% of the entire index.
An equal-weighted index fund, on the other hand, takes the same set of companies, and invests in them as equally as it can. An S&P 500 equally weighted index, for example, puts the same amount of money into Apple as it does into American Express. It’ll put about the same amount of money into all of the companies in the index, regardless of their relative size.
Momentum vs Value
Indices that are weighted by market capitalization are inherently momentum-based. When a stock starts increasing in share price, the indices hold onto the stock and automatically begin increasing its weighting in the index. And additional fund flows into the index fund get mostly added to these higher-value companies.
This can be a good or bad thing depending on why it’s increasing in price. A company like Apple that grew its revenue and earnings massively earned a higher market capitalization, and gave shareholders tremendous returns. But on the other hand, you can imagine a scenario (like in the Dotcom Bubble), where a company’s market capitalization simply becomes overvalued without it being earned. Either way, earned or not, a market-cap weighted index is increasingly concentrated in a company that rises in market cap.
Likewise, when a stock starts decreasing in share price, the indices naturally decrease their weighting as the company shrinks in market capitalization. Additional fund flows into the index fund are likewise invested less in these underperforming companies, because their market capitalizations are smaller.
In contrast, indices that are weighted equally are inherently value-based. The index fund is divided equally between all companies that are included in the index, so when shares of company A go up and shares of company B go down, the fund has to sell some shares of Company A and buy some shares of Company B in order to balance it equally again.
It’s more contrarian, more of a value investing approach, buying out-of-favor companies and selling the popular ones.
But it requires a bit more buying and selling, which can add expenses and taxes. Fortunately, as trading costs have come down over the past few decades, it has become less expensive to operate equal-weighted index funds.
Performance of Equal Weight Indices
Here are three case studies comparing how equally weighted indices compare to their more typical market capitalization weighted cousins.
Case Study #1: Equal Weighted Wilshire 5000
The biggest dataset that I’m aware of for the performance of equal weighted indices is from Wilshire Associates. You can download the performance data for all of their indices here.
The Wilshire 5000 is the best representation we have of the United States stock market. It tracks almost all publicly traded companies in the United States from small cap through mega cap companies, except for penny stocks and other tiny companies.
Using Wilshire’s data, here’s a chart of how the equal weighted version has performed over almost 50 years compared to the market capitalization weighted version:
This is an index rather than an actual fund, but hypothetically for every dollar you invested into the standard Wilshire 5000 market capitalization weighted index at the end of 1970, you’d have more than $102 by the end of 2016. The blue line looks almost flat on that graph, but it increased by over a hundred-fold, and produced about a 10.5% annualized return.
However, the orange line utterly dwarfs it. For every $1 you put into the Wilshire 5000 equal weight version of the index at the end of 1970, you’d have over $1,458 by the end of 2016. That’s an order of magnitude superior returns over nearly a 50 year period, and equals about 17.1% annualized returns.
Plus, the equal weighted version outperformed every single decade. So, although it was more volatile, its outperformance was consistent decade after decade without fail.
There are, however, some major caveats:
- There’s no way to directly invest in the Wilshire 5000 equal weight index.
- The equal weighted version would have had significantly higher turnover, and thus higher fees and less efficient taxation.
Still, we’re talking 14x better performance as the baseline, for a huge set of companies over an extremely long timeline.
Case Study #2: Equal Weighted S&P 500
The previous example was hypothetical, but this one is practical.
The Invesco S&P 500 Equal Weight ETF (ticker: RSP) was launched in 2003. It has about $15 billion in assets under management and has an expense ratio of 0.40%.
Here’s how it has fared compared to the SPDR S&P 500 Trust ETF (ticker: SPY), which is a cap-weighted index with $260 billion in assets and an expense ratio of 0.0945%, courtesy of Google Finance:
The blue line is the cap weighted index ETF while the red line is the equal weighted index ETF.
This one is closer, and we only have 15 years of data, but so far, the equal weight one is significantly outperforming. Even after you account for the higher expense ratio and the fact that its distribution yield is a few tenths of a percent lower, the outperformance is still meaningful. Especially if you extrapolate this over a 40 year investing career until you retire.
However, note that in 2009, the drawdown of RSP was significantly bigger, and was enough to bring it down to the level of the standard cap-weighted index. It’s possible that the next market correction will bring it lower towards the other one again, at least temporarily.
Since equal-weighted indices are less focused on mega-cap companies and have a bigger mid-cap base, they’re more volatile and may provide better overall returns. They fall more severely during recessions but rebound more strongly during bull markets from what we’ve seen so far.
Case Study #3: Equal Weighted NASDAQ 100
There’s an equal weight ETF of the NASDAQ 100, called the Direxion NASDAQ-100 Equal Weighted Index Shares (ticker: QQQE). Its inception was in 2012.
This is their performance, courtesy of Google Finance, compared to the standard NASDAQ index fund (ticker: QQQ):
Over a nearly 7-year period since inception, the equally weighted version has underperformed relative to the standard capitalization weighted version, which makes this example different from the prior two.
Since the NASDAQ 100 is dominated by technology, it could be that technology is simply different than other sectors when it comes to this. Many of the largest IT companies benefit from the network effect or from massive scale, meaning the more people that use their services the better the service becomes. Maybe cap-weighting is the way to go here.
Or it could just be luck with a fairly small sample size. The cap-weighted version dis-proportionally benefited from the rise of Amazon, Apple, Facebook, and Alphabet. Perhaps the massive ascendancy of just these four companies in this particular decade is an anomaly that made the cap-weighted version outperform the equal-weighted one.
We don’t have enough data to say yet, but this one is in favor of cap-weighting with the limited data available.
Pros & Cons of Equal Weighted Indices
Although equal weighted ones may or may not have truly better performance, especially when you stick to the broad market or the S&P 500, there are definitely some trade-offs.
- Under the largest sample sizes, their long-term performance appears to be superior.
- They’re more diversified, rather than heavily concentrated into just the largest companies of the index.
- They naturally take a value-approach, which some investors prefer.
- They have higher turnover, which leads to higher expense ratios and generally higher capital gains taxes.
- They’re more volatile, and can fall more sharply during recessions.
- They’re only available for certain indices, because they’re not as popular yet.
- There are some interesting anomalies. For example if Apple were to split into two companies, a cap-weighted index would still have the same amount in it because the two parts would have about the same market cap when added together, while an equal-weighted one would double its exposure to it because it’s now two names and would invest in each equally.
- Changing the way the index is weighted changes the sector balance. Here’s an example for the S&P 500:
As you can see, the main difference is that the cap-weighted (SPY) version is far more weighted into IT. This is neither particularly good or bad in principle; it’s just another difference to be aware of.
And this can vary over time. Right now, Amazon, Facebook, Apple, and Alphabet are driving the bulk of that difference.
Build Your Own Equal Weight Index Fund
One of my investment accounts is at M1 Finance, because it allows me to construct my own equal weight index funds for free.
M1 Finance is a free investment platform that lets you invest in ETFs and/or individual stocks. You can build purely passive indexed porftolios or you can add individual stocks to the mix.
The way it works is that you construct an “investment pie” that contains one or more investments, and then you can build your portfolio out of one or more investment pies.
For example, you could keep it really simple and just have a portfolio that has:
- 40% U.S. Stocks (Vanguard VTI)
- 20% Foreign Developed Stocks (Vanguard VEA)
- 10% Emerging Market Stocks (Vanguard VWO)
- 40% bonds (Vanguard BND)
Or, if you want to get fancy, you can build a investment pie that is equally-weighted. For example, they have a pre-built one you can use called the Blue Chip 20, which is equally-weighted into the largest 20 companies trading on U.S. markets:
Source: M1 Finance
I personally built my own dividend stock investment pie that is equally weighted among about 17 dividend-paying companies. You could also build much larger ones.
And because I add new capital every month or two, there’s no need for turnover in my portfolio. My deposits are automatically put towards re-balancing my portfolio, so for example if Stock A is up quite a bit and Stock B is down quite a bit, my contributions would put more towards Stock B to re-balance towards equal weighting. No selling is required to maintain equal weights.
However, I could also simply press the “Rebalance” button and the portfolio would automatically go back to perfect weighting that way as well.
You can make an account for free and poke around and build some portfolios before deciding to add money, if you want.
One takeaway from this may be that, at least in a broad sense, equal weighted index funds are simply better for building wealth over the long-term if you can withstand the added volatility. In that sense, the strategy is simply to buy and hold them instead of the market capitalization weighted varieties.
A more subtle approach is to invest in RSP at the bottom of a market cycle after a big correction, and invest in SPY when markets are expensive, as measured by the Shiller PE Ratio or some other metric. The data we have, both looking at large caps vs mid caps and from looking at equal weighted indices vs cap weighted indices, is that the cap weighted indices that have a bigger focus on larger companies tend to hold up better during market corrections, while the equal weighted varieties with a more balanced large/mid cap spread tend to fall more sharply. Inversely, the equal weighted ones recover more strongly from market bottoms.
It’s hard to say for sure, but evidence leans towards equal weight indices being a bit better. But there’s no compelling knockdown argument for why they’re clearly superior; there’s still a grey area and there’s no 100% clear answer about which is superior.
Equal weight funds used to be restricted by higher costs of trading, but now that the fees associated with trading are so low, perhaps, the cost difference between equal weight funds is overshadowed by their potentially superior performance.
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