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By Simon Constable 

As recent market action shows, there are perils with investments that track market-capitalization-weighted indexes -- especially when a rally goes into reverse.

For example, investors who buy SPDR S&P 500 (SPY) exchange-traded fund, which tracks the largest U.S. listed companies, might think their portfolio is diversified. But that is only sort of true, especially in the current market where the index is heavily weighted with technology stocks such as Amazon.com, Apple and Google parent Alphabet.

"The market is more concentrated [in one sector] than it has historically been," says Todd Rosenbluth, head of ETF and mutual-fund research at New York financial-research firm CFRA.

That's because the S&P 500 weights the component stocks by their market capitalization, meaning bigger companies take a larger share of the index. Given that tech stocks have been on a tear lately, they now take an outsize portion of the index.

A similar index known as the S&P 500 equal-weight index, tracked by Invesco S&P 500 Equal Weight ETF (RSP), may provide more diversification for investors because it is constructed in a different manner. Each stock has the same weight in the index regardless of the size of the company. The index gets reset to equal weight each quarter to take account of the price moves in the component stocks, Mr. Rosenbluth says.

The pros and cons

There are pros and cons to holding funds that track either type of index, but here are the basic need-to-know details on each type of investment.

As of Oct. 30, the tech sector made up 27.4% of the S&P 500 index, while the energy sector represented a near-negligible 2%, according to data from S&P Global. That means small moves in the price of Apple and Microsoft will ultimately have a much larger impact on the performance of the SPDR fund than massive moves in energy stocks such as Exxon Mobil.

On the other hand, with the equal-weight index, a 5% move in Apple stock will have a similar impact on the performance of the index as a 5% move in Exxon Mobil. "There's greater diversification with the equally weighted fund than there is with the market-cap-weighted one," says Bob Stammers, director of investor engagement at the CFA Institute in Atlanta.

With the market-cap-weighted fund, you can get more of the concentrated exposure to certain sectors just as investors have seen with tech recently, he says. "As the biggest stocks go up in value, you get more exposure, and you could have much larger swings in the value of the index if those largest stocks are volatile," Mr. Stammers says. More volatility is exactly the opposite of what portfolio diversification is supposed to achieve. By holding stocks in lots of different sectors of the economy, the idea is that when some areas do poorly, others do better. In short, true diversification means that you get a smoother ride for your investments.

Because of the rebalancing methodology, equal-weight indexes follow the practice of selling a portion of the winning stocks and buying some more of the underperformers. The idea is that no sector keeps going up forever. All sectors have bad years where they underperform the broader index and vice versa.

"I think everyone knows that you should sell your winners and buy your losers," Mr. Rosenbluth says. "Equal-weight strategy is similar in nature to rotating into what hasn't worked out on the assumption that it will come back." Vice versa is also true.

For instance, in 2018, the health-care sector was the best performer in the S&P 500, with total returns of 6.5% versus a loss of 4.4% for the overall index. The next year, 2019, it was one of the worst performers, lagging behind the S&P 500 by more than 10 percentage points, according to data from CFRA. Or put another way, selling some of your health-care holdings in late 2018 and investing them in other sectors would have served investors well.

Cap-weighted fans

However, not everyone sees things that way. Others see the market-cap-weighted index as better because it follows the winners and dumps the losers. And in market capitalism, companies that continually underperform eventually tend to go out of business or get ditched from the large-cap indexes.

"The S&P is the greatest momentum strategy in the world because it buys more of the best ones and kicks out the bad ones," says JC Parets, founder of technical analysis firm AllStarCharts.com. Technical analysts, or chartists, look at price chart patterns to forecast which direction stocks will move.

So which strategy has worked best? It depends on what period you look at. In one analysis, the total return from April 25, 2003, through Oct. 26 this year showed that the equal-weight Invesco fund had annualized returns of 10.5% versus 9.93% annualized returns for the SPDR fund over the same period, according to Morningstar. The inception of the Invesco fund occurred on April 24, 2003, so a longer comparison isn't possible.

If you look at the past 10 full calendar years (2010 through 2019), each of the two approaches bested the other in five of the 10 years. However, in four of the past five years, the market-cap-weighted SPDR fund has had better returns. That leads some to believe that a reversal of fortune back to equal-weight investing being the winning strategy may be in the cards soon.

"When the market-cap-weighted S&P has beaten the equally weighted S&P, it rarely happens for this big a period," says Mr. Rosenbluth. "When that has happened, we see the equal-weighted index catch up."

Mr. Constable is a writer in Edinburgh, Scotland. He can be reached at reports@wsj.com.

(END) Dow Jones Newswires

November 08, 2020 12:16 ET (17:16 GMT)

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