If you are new to investing, you’ve probably heard this a lot of times :“you should invest in a low-cost S&P 500 index fund”. Even Warren Buffett has said it several times during his Annual Shareholders meetings. The thing is, many people don’t tell you which one… Should you choose a market-cap-weighted S&P 500 index fund or an equal-weighted S&P 500 index fund? What are the differences? Let’s find out more!
An S&P 500 ETF, the easiest and best choice ever?
When people talk about the performance of the S&P 500, they often refer to the performance of SPDR S&P 500 ETF (ticker symbol: SPY) or the one from Vanguard (ticker symbol: VOO). Of course, that makes sense. The SPY is one the largest and most traded ETFs in the world that holds the S&P 500 constituents.
However, the percentage of ownership of these ETFs in each company of the S&P 500 is determined very differently than you may think. In case you thought that by investing EUR 500 in the SPY (or VUSA in The Netherlands) you have the same exposure to each of the 500 companies (EUR 1 each), you are completely wrong. That’s because of the ‘market-cap-weighted’ methodology.
A simplified example of the market-cap-weighted methodology
The thing with a market-cap-weighted methodology is that the largest companies (based on their market-cap) have the heaviest weighting in the index.
To give a simplified (and hypothetical) example, if Microsoft doubles in market-cap (stock price x number of outstanding shares) today, the weighting in the index doubles as well (all else being equal). So, Microsoft goes from a 6% weighting in the index to about a 12% weighting in the index.
From a diversification standpoint, this seems completely illogical. However, one of the reasons for this approach is that it’s much easier to run an efficient index fund or ETF that way. The larger the fund gets in terms of money inflow, the easier it gets to allocate that additional money inflow to companies that have much better liquidity in the stock markets (and have a large market-cap).
It’s much harder (and more expensive) to allocate the additional money inflow to dozens of smaller companies than to buy for example EUR 1 billion of stock of Apple. Because remember, for every buyer of stock there needs to be a seller of stock.
What are the largest holdings in the S&P 500 (market-cap-weighted)?
As you can see in this table a significant portion of your money is invested in tech stocks. This can make a lot of sense if you expect tech to grow even further. In any case, you are betting a significant portion of your money on that it does.
This seems at odds with protecting your wealth and safeguarding yourself from losing a significant portion of your money. On the other hand, if tech soars you will benefit significantly.
What sectors does the S&P 500 (market-cap-weighted) ETF cover?
Investing in the S&P 500 is always portrayed as investing in America. Of course, this is still true. Although it makes sense to rephrase this somewhat. With a market-cap-weighted S&P 500 ETF you significantly bet on the United States tech sector. As you can see above, 32% of a S&P 500 market-cap weighted ETF is allocated to tech.
If tech turns sour, 32% of your portfolio is impacted because of large stakes in Microsoft, Apple, Amazon, Facebook and Google (Alphabet).
The S&P 500 market-cap-weighted ETF focuses at mega-cap companies
The tables below show the allocation based on company size:
As you probably already saw in the tables above, 95% of your money flows to large-cap companies with a market-cap of USD 13 billion or more. I prefer to speak of mega-cap instead of large-cap. Your money flows to companies that have an average market-cap of USD 340 billion! That’s insane. Like there is nothing else in the United States than mega-cap companies.
It’s not that I want to bash the cap-weighted S&P 500 ETF, but to me it doesn’t really make sense. Certainly not because people new to investing are probably not even aware of this. The only thing new investors hear is “invest in an low-cost S&P 500 ETF”. This isn’t necessarily a wrong choice, as long as you aware of how a market-cap-weighted ETF works.
However, personally, from a diversification perspective this seems financially irresponsible. The United States (and the world for that matter) is broader than tech. I wanted a ‘set-and-forget’ portfolio which is highly diversified that delivers market returns. That’s what led me to ‘equal-weigted’ ETFs.
A (non-simplified) explanation of the equal-weighted S&P 500 index methodology
The reason I included ‘non-simplified’ in the header, is because it’s just easy to explain. In contrast to a market-cap-weighted methodology which requires a lot more explanation.
An equal-weighted S&P 500 index invests any money that flows into that fund equally among the constituents of the index. With my best math, 100% divided by 500 (actually a little bit over 500) = 0.2%. Each company in the index has a weighting of 0.2%. That’s it.
Obviously, the value of the underlying companies changes over time. If the stock price of Apple sky-rockets it can become 0.3% or 0.4% of the index. The same thing the other way around.
That’s why the portfolio is rebalanced on a quarterly or yearly basis. After rebalancing, every company in the index represents 0.2% again.
The added benefit is that stocks that have increased in value (>0.2%) are sold off to return to 0.2%. Stocks that have decreased in value (<0.2%) are purchased to return to 0.2%. This is an easy way of selling high and buying low.
What are the largest holdings in the S&P 500 (equal-weighted)?
As you can see below, the 10 largest holdings in the equal-weight index total 2.45%! This is incredibly low compared to the market-cap-weighted top 10 holdings which equals 26.8%.
Also, if you look at the percentage of the portfolio that is allocated to the tech sector, this turns out to be almost 15% compared to the 32% in the market-cap-weighted index. From a diversification perspective this makes a lot more sense.
An equal-weighted S&P 500 index is tilted more towards mid and small-cap companies
As you can see below, the weighted average market cap now shows USD 52 billion. If you compare this to the market-cap-weighted index, at USD 340 billion, this is much lower.
This tilt towards mid- and small-cap companies makes the equal-weighted ETF more an all-round representation of the United States economy. The higher dividend yield of 2.57% compared to 1.94% can make this equal-weighted ETF more attractive for income investors while still ensuring very low concentration risk.
Performance of the S&P 500 market-cap-weighted versus S&P 500 equal-weighted ETF
Let’s now take a look at how S&P 500 based on two different methodologies stack up to each other from a performance perspective.
I’ve used the following two ETFs:
- SPDR S&P 500 ETF (SPY)
- Invesco S&P 500 Equal Weight ETF (RSP)
I compared these two ETFs by using PortfolioVisualizer.com by backtesting the performance as far back as possible.
The result is almost similar. But if you look at the chart it gives an interesting perspective:
You can see that the equal-weight ETF is way up at almost any period in the past 16 years. If you exclude the COVID-19 pandemic the result is as follows:
An almost 10% difference over a period of 16 years. This may seem not that much. But don’t forget that the largest part of the stellar performance in the S&P 500 (market-cap-weighted) index is the result of large players such as Apple, Google, Microsoft, Facebook and Amazon.
No one can look into the future, but I just don’t know whether these companies can maintain their track-record for the next 15-20 years. History has shown that even the greatest and most solid companies in the world can be gone in no time.
Personally, I find a diversified equal weight ETF a good addition to my portfolio
I prefer an equal-weighted index that provides diversification across the S&P 500 in its entirety. No significant dominance of any sector such as tech. But if you would ask me “should I buy an market-cap-weighted S&P 500 ETF or an equal weighted S&P 500 ETF?”, my answer would be I’m not sure.
The evidence seems to be in favor of an equal weight ETF, especially from a diversification perspective. But you have to determinethat out for yourself! So, please remember, I’m not a stock advisor. I’m just sharing my perspective.