As big-cap tech approaches new heights, some are putting more emphasis on equal weight. It is not clear that it is the right bet. Nearly half of the largest technology stocks are now at or less than 1% from a 52-week high, including Microsoft, Nvidia, Salesforce, Broadcom, Meta, Oracle, Lam Research, Applied Materials and Alphabet. Apple is 2% from a new high. The top 10 stocks in the S&P 500 now account for 30% of the entire market weight in the index, the highest in decades. To reduce concentration risk, some in the investment community who long ago converted to indexing with market capitalization-weighted indexes are urging investors to instead look at owning indexes that equate to the S&P and other popular indexes. With more than $7 trillion indexed to the S&P 500, this is not an academic debate. “There’s a lot of consternation about the contribution of the five to 10 largest stocks to YTD performance, and while that’s what major weights in cap-weight indexes should do, we’d rather not see them deviate further from the ‘average’ stock,” Strategas’ Todd Sohn wrote in a recent note to clients. The ‘average’ stock has gone nowhere this year And yet the ‘average’ stock has indeed deviated from the index. But not in a good way. With the S&P 500 up 8% this year, the average stock, as represented by the S&P Equal Weight ETF (RSP), is up a measly 0.5%. The RSP has underperformed the market-cap-weighted S&P 500 month-to-date, quarter-to-date, and year-to-date. That is an unusually wide divergence. Predictably, this has led to a lot of hand-wringing that something is terribly wrong with the market. The Argument for Equal Weight The argument for balance is based in simple history. Over the 20-year history of the RSP, it has outperformed the S&P-weighted S&P on a pure price basis (not including fees): Equal-weight vs Market Cap-weight (past 20 years) S&P 500 ( equal): +425% S & P 500 (market cap weight): +340% There are several reasons that equal weight has outperformed during this period. First, academic research indicates that over long periods (decades) there is a modest outperformance of smaller stocks over larger stocks, and of value stocks over growth stocks. A balanced index would tilt towards both factors. Take small- and medium-sized stocks. By definition, balance allows these stocks to have an equal impact with larger stocks. “By allocating balance to S&P 500 constituents (at) each quarterly rebalancing, the current index is less sensitive to the performance of the bigger names in the market,” Hamish Preston, director of US equity indices for S&P Dow Jones Indices, said in a recent presentation. Preston said about 50% of the variation in returns can be attributed to smaller size. Another factor in the long-term outperformance comes from what Preston calls the “anti-momentum” effect: the balanced index rebalances on a quarterly basis, so it sells shares of companies that have increased in value, and buys shares that have decreased in value. This is essentially a “value” play. Finally, there is sector exposure. Tech stocks, which had a large market weight during the dot-com boom of the late 1990s, slumped for much of the early 2000s, leading to underperformance for the market-cap weighted S&P. Last year, low market-cap sectors like energy companies outperformed, while large market-cap sectors like technology underperformed, and the equal weight obviously did better. This year that is reversed. A benchmark for managers of equal weight? Active managers have been known for decades to underperform their benchmarks when measured over longer periods. An argument could be made that active managers invest more than a balanced index. “There is plenty of research indicating that active managers have a portfolio construction that is closer to balanced than cap-weighted, and so balanced may be a more appropriate benchmark for many,” Preston said. For example, in the S & P Technology Index, three stocks are 50% of that index. In the Consumer Discretionary Index, the top 3 names account for almost 45%. An “investor who wants to gain exposure to the economics of the sector, and invest for the developments in that sector, will be better off with an equal weighting of that sector, as they will have a broader exposure to the businesses in that industry,” Preston said. Unfortunately, shifting the bogey does not improve the performance of active managers. Beating benchmarks of any type is difficult, Preston said. He noted that over the 20-year period ending in June 2022, 95% of large-cap managers will underperform the S&P 500, and 99% will underperform the equal-weight S&P. Investing has many supporters, equity indices are still a distinct minority in the investing world. The reason: Most investors believe that the public rightly votes on which stocks win and lose, and market capitalization is a better reflection of that vote. While that view—”let the market decide who the winners and losers should be”—is still the dominant way of thinking, proponents of equity indexing point out that a small but growing minority of the investing public is more concerned about safety than outperformance. “I think there is evidence that the winner-take-all nature of modern capitalism is accelerating, not slowing down, which makes the case for equal weight really about safety, not outperformance,” said Dave Nadig, the financial futurist at VettaFi, in an email.
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