Do equal weighted stock market index tracking funds outperform conventional market cap weighted funds?
Most of us will not be able to beat a given stock market index in our investment. This includes most if not all professional fund managers over the long term.
These days we are lucky enough to have a cheap and simple route to invest in index tracking funds, but traditionally most indices have been weighted by market capitalization.
What this means is that an index like the S&P 500 and an index tracker like SPY (the SPDR S&P 500 ETF) is dominated by the biggest US companies such as Microsoft, Apple, Facebook, Amazon and Google which each constitute 3% to 4% of the index. These companies currently represent over 15% of the S&P 500.
Which is all well and good but eventually big companies plateau. They run out of room to grow. Nothing goes up forever or continues to grow exponentially.
At the bottom end of the index, a company may represent as little as 0.02% of the index. The median weighting in the index is 0.086
So growing companies are vastly under represented because they are small and yet they may have greater growth potential than the Goliaths.
When you look at equal weighted indices, these attempt to invest the same amount in each company in an index: in other words each company in the S&P 500 would receive a 0.2% weighting.
The above chart is for the Invesco S&P 500 Equal Weight ETF (RSP) compared to an ETF which follows conventional market capitalization weighting – SPDR S&P 500 ETF (SPY).
Note the considerable out-performance of the equal weighted ETF since its inception. According to information provided by Yahoo Finance, each has recorded the following dividend re-invested compound annual growth since April 2003:
- SPY 9.44%
- RSP 10.84%
There is nothing particularly fancy about such a fund or its arithmetic. But it is as well to be aware that historically at least you may have done better with “equal weighting” than “market capitalization weighting”.
There are 109 equal weighted ETFs trading on US exchanges. In the UK there are a number of equal weighted ETFs available such as Db X-trackers FTSE equal weight UCITS (XFEW). For those wanting to venture further afield, perhaps Ossiam STOXX® Europe 600 Equal Weight NR UCITS ETF is worth looking at.
Doubtless you will be able to find many other equal weighted ETFs covering many more markets.