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 funds historically produce superior returns.
But the reasons why are complex and inconsistent, 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 an 8x bigger market capitalization than American Express, for example, and so the S&P 500 invests 8x 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 its focus is on large cap, mid cap, small cap, REITs, or anything else.
In fact, although the S&P 500 consists of 500 companies, the top 10 holdings in the list make up 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, and then rebalance back to those equal weights regularly.
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 more shares of out-of-favor companies and trimming the shares of the recently 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. And taxes aren’t a factor in retirement accounts.
Performance of Equal Weight Indices
Here are four case studies comparing how equally weighted indices compare to their more typical market capitalization weighted cousins.
Case Study #1: Equal Weighted Wilshire Large-Cap
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. I can’t write too much detail about it because they have restrictions on terms of use outside of personal use.
However, as a conclusion, from 1978 to the present with dividends reinvested, their equal weight large cap index of 750 large companies has outperformed their market-cap weight index of the same companies, and more closely-matched the performance of their mid-cap index:
The equal weight index grew at 12.5% annually compared to only 11.4% for the market weight index, which adds up to a lot more than it sounds. Over a four-decade investing career, hypothetical investors would have about 50% more money from focusing on mid-caps or equal-weighted large caps.
In practice, that would likely be trimmed by a few tenths of a percent annually for higher fees.
(For the record, market-weighted micro-cap stocks did the worst in Wilshire’s database, and market-weighted small-cap stocks slightly underperformed market-weighted mid-cap stocks and equal-weighted large cap stocks.)
Case Study #2: Equal Weighted S&P 500
The previous example was hypothetical because the strategy was not really investable for most of that period, 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 just 0.20% after reducing it over time.
Here’s how it has fared compared to the SPDR S&P 500 Trust ETF (ticker: SPY), which is a cap-weighted index with an expense ratio of 0.0945%:
Chart Source: YCharts
This one is closer, and we only have a little over 15 years of data, but so far, the equal weight one is significantly outperforming even after the slightly higher fees. Especially if you extrapolate this over a 40 year investing career.
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 Sectors
Invesco has several equal weight sector-specific ETFs that were created in November 2006, which gives us 13 years of data to work with, including a recessionary period. They focus on specific subsets of the S&P 500, so they are large companies.
Here are the cumulative returns you would have received with dividends reinvested from these equal weight sector ETFs compared to the market weight SPDR sector ETF equivalents since the inception of the equal weight versions in November 1, 2006 until August 23, 2019:
| Sector | Equal Weight | Market Weight |
|---|---|---|
| Staples (RHS vs XLP) | 263% | 223% |
| Discretionary (RCD vs XLY) | 156% | 277% |
| Industrials (RGI vs XLI) | 201% | 179% |
| Financials (RYF vs XLF) | 51% | 17% |
| Health Care (RYH vs XLV) | 317% | 231% |
| Technology (RYT vs XLK) | 293% | 314% |
| Energy (RYE vs XLE) | 3% | 33% |
| Materials (RTM vs XLB) | 161% | 119% |
| Utilities (RYU vs XLU) | 185% | 174% |
The real estate sector and communications services sector are excluded because they are new sectors that were created in 2015 and 2018 respectively, and thus have less useful data. I’m sticking with the subset that have data going back to November 2006.
Out of the nine included sectors, the equal weight versions came out ahead six times and the market weight versions came out ahead three times. So, there is a lot of uncertainty, but we can dig through the various reasons. Let’s look at the four sectors where the market weight version outperformed.
The consumer discretionary sector includes Amazon and other retailers, so that’s easy. Amazon is basically a tech stock, since it also has the cloud computing side of it and was a pure online retailer, and was one of the best-performing stocks in the world, became a trillion-dollar company, and utterly dominated the sector. The market weight version kept weighting it higher and higher (up to over 20% of the whole ETF) while the equal weight one only has tiny exposure to it.
The technology sector included Apple and Microsoft, which became trillion-dollar companies. The market weight one has huge exposure to them, and mildly outperformed the equal weight version.
The energy sector performed terribly, but the larger ones seemed to have held up better.
According to a 2014 study by Michael Cembalest, Chairman of Market and Investment Strategy at J.P. Morgan Asset Management, the information technology sector has the highest percentage of catastrophic capital loss out of all sectors, at 57%. Catastrophic loss in this case is defined as the stock falling by 70% or more and then not recovering much at all.
If you have a set of companies where some of them grow 10-fold or 100-fold and a high percentage of other ones crash and never recover, one would suspect that market-cap weighting may outperform equal weighting. If you stick to market-cap weighting, then one or two enormous winners can wipe away the losses of the high percentage of companies that fail in this sector, which is what we have seen with some of the more volatile sectors in this sample (tech, discretionary, energy, and financials).
The conclusion for this case study is likely that equal weighting does better with high-quality companies with low catastrophic failure rates, while market weighting does better in winner-take-all environments with high catastrophic failure rates.
Additionally, sector ETFs don’t benefit from inter-sector rebalancing like the equal weight S&P 500 does, which means they miss out on a key benefit. If, say, the price of energy crashes, an equal weight S&P 500 fund would rebalance into it from other sectors, and basically buy the dip in those companies like a value investor. On the other hand, the market weight version of the S&P 500 would ignore the crash and just let that sector shrink, and not buy the dip.
Case Study #4: Equal Weighted MSCI Indices
MSCI has equal-weight versions of their main global indices going back to June 1994. In the 25 years since then, these have been their average annual returns, including reinvested dividends, compared to their market-weighted versions:
| Region | Market Weight | Equal Weight |
|---|---|---|
| MSCI USA | 9.78% | 10.60% |
| MSCI World | 7.35% | 7.59% |
| MSCI ACWI | 7.18% | 7.12% |
| MSCI EM | 5.60% | 5.76% |
In three out of the four, the equal weight versions mildly outperformed. The biggest positive gap was for the MSCI USA index with a substantial 0.82% annual difference. For the ACWI one which has underperformed, it was by a very small margin.
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.
Pros:
- Under the largest sample sizes, their long-term performance appears to be superior, at least for non-tech groupings.
- 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.
Cons:
- 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.
- Sectors with high catastrophic loss rates, like information technology, may underperform with equal weighting.
- 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.
Neutral:
- Changing the way the index is weighted changes the sector balance. Here’s an example for the S&P 500:
Source: SPY Holdings List and RSP Holdings List
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. (See my disclosure policy here regarding my affiliation with M1.)
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)
- 30% 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.
See my disclosure policy here regarding my affiliation with M1.
Final Words
One takeaway from this may be that, at least in a broad sense, equal weighted index funds are slightly 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 similar argument could be made for investing more heavily in mid-cap stocks in general.
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.
But there’s no compelling knockdown argument for why they’re clearly superior; it’s a gray area and there’s no 100% clear answer about which is better. The information technology sector, and other other industry subsets like biotech and metal mining that have high rates of catastrophic loss, may be less suitable for equal weight investing.
For my own money, I prefer a strategy closer to equal-weighting for blue-chip mid-cap and large-cap companies. By sticking to companies with high returns on invested capital, strong balance sheets, and favorable secular trends, the rate of catastrophic loss should be low, and thus the small cumulative effects of equal weighting are perhaps more likely to be worthwhile.
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