Owning an equal part of every business in town

Investment process

S&P 500 index vs S&P 500 Equal Weight

In this post I will discuss the relative merits of buying a small equal piece of 500 U.S. companies. There’s an easy way to do it. You can buy a unit in an ETF that tracks the S&P 500 Equal Weight index.

It’s not what I do. I invest in a concentrated portfolio of carefully chosen companies. But my children are not into DIY common stock investing. They invest in ETFs. I offer them guidance on their investing.  

DIY concentrated portfolio vs passive

It is not easy to invest directly in a small portfolio of common stocks. It takes time and effort, through study and the school of hard knocks, to develop a sound investment process. To my way of thinking, the results well justify the effort.

Most investors will do well with passive index funds especially if they simply invest and leave them alone through thick and thin.

S&P 500 index vs S&P 500 Equal Weight

The S&P 500 index is Market Capitalization weighted (cap weighted). That is, the largest companies by capitalization have the greatest weight in the index. The smallest by cap have proportionally less weighting. One of the largest ETFs is Vanguard S&P 500 ETF (ticker VOO) which trades on the NYSE. It invests in the stocks that make up the S&P 500 index, holding each stock in more or less the same proportion as its weighting in the index. Something like $500 billion is invested in this ETF.

For years I thought that this ETF, or similar ones, were the best way to invest passively in stocks and take advantage of the general outperformance of stocks over bonds in the long haul.

Then I read a reference to Joel Greenblatt’s book The Big Secret for the Small Investor in Blog | The Acquirer’s Multiple®

One of Greenblatt’s themes is that market cap weighting guarantees an imbalanced portfolio, that it favours overpriced stocks and underweights bargain priced ones.

Here’s how Greenblatt puts it: “Remember, a market-cap-weighted index ends up having a larger weighting in stocks that increase in [price] and a smaller weighting in companies whose prices decrease. As Mr. Market gets overly excited about certain companies and overpays, their weighting in a market-cap-weighted index rises.

Consequently, an index fund that owns these same stocks ends up being more heavily weighted in these overpriced stocks.

If Mr. Market is overly pessimistic about particular companies or industries, the opposite happens. The stock prices of these companies fall below fair value, and the index and the accompanying index fund effectively own less of these bargain-priced stocks.

In fact, the effect of owning too much of the overpriced stocks and too little of the bargain-priced stocks is actually built into the market-cap-weighting system. Again, as stocks move up in price, we own more of them through the index. As stocks move down in price, we own less of them.”

What this suggests is that the total return performance of a cap weighted index should, over time, be less than an equal weighted index. This turned my head as I had always assumed an index tracking the S&P 500 was the best passive way to invest in stocks.

Compare this with the words of Warren Buffett in the 1991 Berkshire Hathaway Annual Letter :

“I certainly would not wish to own an equal part of every business in town. Why, then, should Berkshire take a different tack when dealing with the larger universe of public companies? And since finding great businesses and outstanding managers is so difficult, why should we discard proven products? (I was tempted to say ‘The real thing.’) Our motto is: ‘If at first you do succeed, quit trying.’”

The conclusion I have come to is that Buffett is right for an actively managed portfolio and that Greenblatt is right for a passive portfolio.

Let’s look at the results for the Invesco S&P 500 Equal Weight index ETF. Its ticker is RSP and it trades on the NYSE and has a market cap of $72 billion.

RSP’s total return since 2003 is 575% compared with 514% for SPX which is the S&P 500. The Equal Weight index seems to have beaten the market!

Research to explain why – First Report

There is now research that offers some explanations for this result. The first of two reports I will refer to is ‘20 Years of the S&P 500 Equal Weight Index’ published in June 2023 by S&P Dow Jones Indices, a Division of S&P Global.

The authors conclude that “The ability to avoid concentration in the largest stocks and the discipline of regular rebalancing are virtues sometimes ascribed exclusively to active management. Both are encoded in the design of the S&P 500 Equal Weight Index.”

This doesn’t really help in understanding why Equal Weight beats Cap Weight.

Second Report

The second report, also published by S&P Dow Jones Indices and dated January 2018, is titled Outperformance in Equal-Weight Indices – Research | S&P Dow Jones Indices

Size exposure

This second report sheds more light on the things at play. First, it is noted that equal-weight indices typically display a greater participation in the performance of smaller companies. This effect is more pronounced in a large cap index like the S&P 500. Their research suggests that size exposure alone explains a considerable portion of the S&P 500 Equal Weight Index’s long-term returns. 

Rebalancing on a regular schedule – selling winners!

Second, an equal-weight index is defined by a rebalancing schedule specifying the frequency at which constituents should be rebalanced to equal weights. The S&P 500 Equal Weight index, for example, includes all S&P 500 constituents, rebalanced quarterly. 

An equal weight index sells relative winners and purchases relative losers at each rebalance.  Momentum-based strategies typically follow the opposite pattern—buying winners and selling losers—which suggests the potential for a connection in their performance.

According to their research, this “anti-momentum” bias may explain a further significant portion of S&P 500 Equal Weight Index’s long-term positive return compared with the cap weighted index. I confess I don’t really understand this. But I don’t dismiss it out of hand. On the contrary, I give it some weight until some other explanation makes sense.

Remember Greenblatt’s points: market cap weighting guarantees an imbalanced portfolio, that it favours overpriced stocks and underweights bargain prices ones. This is different from the explanation given by the S&P Dow Jones Indices research although is fits with the anti-momentum bias. Except that the selling of winners would be, in effect, selling of overpriced stocks and rebalancing to underpriced one.

Further thoughts

It also occurs to me that the largest cap companies in the S&P 500 are probably further along the path to the end of their corporate life cycle than smaller companies.

In January 2000, twenty-four years ago, the ten largest capitalization companies in the S&P 500 were Microsoft, Cisco Systems, Exxon Mobil, Intel, Citigroup, IBM, General Electric, Oracle, and Home Depot. They were the Class of 2000 mega-caps. Where are they now? A cap weighted index over the last twenty-four years carries the weight of the losers in this group as well as the winners. On this theory it would not be size exposure directly that would impact returns so much the waning end of corporate life cycles. There would be a size correlation but not size causation so much a life cycle causation. On this topic take a look at my post Concentration risk and the Magnificent Seven

Conclusion

I surprised myself when looking into this question. I had thought that a low fee S&P 500 index fund was the best approach to passive investing in common stocks. My further reading and thinking suggest that a low fee S&P 500 Equal Weight Index ETF may, in fact, have a performance edge. Happy to engage in a discussion on this.

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You can reach me by email at rodney@investingmotherlode.com

I’m also on Twitter @rodneylksmith

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