Why an Equal-Weighted Index Is Not in Fact Equal

Given that the “Magnificent Seven¹” have driven almost all of the gain in US large cap stocks year to date,² concerns about concentration risk have continued to swell for equity investors. Institutional clients have been asking us more frequently if the time has come to consider an alternative approach to US equity exposure and if an equal-weighted strategy might be more appropriate. In this paper, we explore the tradeoffs and implications associated with implementing an equal-weighted index allocation, rather than a cap-weighted S&P 500 Index exposure.

The New Face of the S&P 500

For many investors, the S&P 500 Index has long been the de facto representation of the US stock market. Investors frequently rely on the Index as a benchmark, a proxy for US large cap equity exposure and a barometer for the demand for risk in the US market. Validating its importance, the Index is the single largest passive exposure held globally by institutional investors, representing over $4 trillion in assets under management.³ State Street Global Advisors alone manages over $750 billion in AUM tracking the S&P 500.⁴

However, the security- and industry-level concentrations in the Index have risen over the past two decades, putting a question mark around the Index’s ability to represent a broad cross-section of US equity performance. As of November 2023, the top 10 largest stocks in the S&P 500 represent 29% of the Index weight and 78% of the Index total return. While this is certainly the largest and most concentrated rally in the last 20 years for the Index, it is a trend that has been steadily on the rise since 2003, when contribution of the top 10 was just 25% of total return (Figure 1).

The small number of names driving S&P 500 Index returns is in itself alarming. But even more striking, 40% of year-to-date returns is attributable to performance in a single industry (information technology). This illustrates the precipitous decline in sector diversity in the Index in recent years (Figure 1). Figures 2 and 3 illustrate that the IT sector has become more and more influential to the Index over the past 20 years. The Herfindahl-Hirschman index (HHI), which we can use to measure the degree of sectoral concentration within indices,⁵ also indicates significantly greater homogeneity within the IT sector versus its long-run average.⁶

The Equal Weight Alternative: What to Consider

With the inherent rise in sector and individual security risks in US large cap indices, some investors are trying to determine whether equal-weighted exposure is the right path. We outline some of the most important ramifications of shifting to an equal-weighted index.

Equal Weighting Explained

The S&P 500 Index is a market-cap-weighted index. By contrast, an equal-weighted index is constructed exactly like it sounds; if there are 500 stocks in an index,⁷ then all 500 are assigned the exact same weight. In the case of the S&P 500, that weight comes out to roughly 20bps per security. What this would mean is that the companies with the highest market caps no longer have the greatest impact on sector weights or index returns. Instead, the largest sector weights will simply be the sectors with the most companies in the index—regardless of price movement (Figure 4). Similarly, the securities with the highest total returns will drive the highest contributions to return.

Portfolio Impacts from Equal Weight Exposure

Reducing sector-level and security-level concentrations seems well and good. However, by doing this, investors would be taking on a different set of risks—a move with potentially deep implications. Looking over the past year, the S&P cap-weighted versus equal-weighted performance differential is the biggest it has been since the past 30 years. Shifting to equal weight could mean:

• Making a bet against the largest names in the cap-weighted index, and a bet on the smaller cap segment.
  About 65% of the S&P 500 is composed of 77 mega cap stocks with market caps greater than $100 billion. Conversely, the S&P 500 equal weight has just 16% weight in the same mega cap names, with the balance in smaller- (read: less mega) cap names between $4 and $100 Billion in market cap (Figures 5 and 6). This is true even though mega cap technology names have given back some of their gains following a strong first half of 2023.

• By transitioning from market-cap weight to equal weight, in the current market, an investor would be effectively migrating a mega cap growth bet to a large cap value bet. Currently,⁸ the S&P 500 Index is tilted towards growth stocks, whereas its equal-weighted counterpart is tilted towards value (Figure 7).

What Historical Data Tells Us

The commentary above may not come as a surprise to anyone. By equal weighting the Index, the style and sector leadership will change, as will the factors driving total return. The ultimate question, though, is whether or not it makes sense to take on the different risks implied by an equal-weighted exposure.

We first note that the S&P equal-weighted index has outperformed its cap-weighted parent only 50% of the time (in 10 of the last 20 years), and cumulative returns over the two decades are almost identical for equal and market-cap-weighted indices (Figure 8).

However, there is a difference in the cumulative historical return for equal- and market-cap-weighted indices when looking at the Sharpe ratio; over time, the Sharpe ratio is higher for the market-cap-weighted index. This may reflect the additional volatility associated with owning S&P equal weight indices versus the market-cap-weighted parent (Figures 9a and 9b).

Investment Implications

Moving from a market-cap-weighted index to equal-weighted does not eliminate all risks; rather, the investor will just be managing different risks. As always, each investor needs to take actions compatible with to their own preferences and risk tolerances.

If the goal is diversification: Investors may be better served by complementing their S&P 500 allocation with small and mid-cap indexes that provide a complete exposure to the remaining US equity market outside of S&P 500 Index constituents.

If the goal is to express a view on a particular investment style or styles, such as size or value: This might be an opportunity for investors to consider smart beta, in which security weighting is not explicitly guided by market cap or other guardrails, and strategies are often put in place to avoid security or security concentrations.