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Following a poor 2022, 2023 has been a good year (to date) for most global equity markets, with the Nasdaq up 41.3% YTD and the S&P500 Market Cap Weighted index up 18.4% YTD (to 29 August 2023).
There has, however, been substantial discussion regarding the limited breadth or narrowness of the US market rally this year, with the top seven megacaps, namely Nvidia (+234% YTD), Meta (+148% YTD), Tesla (+109% YTD), Amazon (+61% YTD), Alphabet (+53% YTD), Apple (+42% YTD) and Microsoft (+38% YTD), driving most of the market return. Megacap tech names have certainly skewed US market performance upwards, with most US stocks flat or even down YTD (with Signature Bank, SVB & First Republic Bank as notable casualties, and more than 40% of stocks down YTD).
The outperformance of these megacaps can largely be attributed to the advancement of artificial intelligence, moderating inflation, and the concomitant hope that peak rates will soon be reached. The extreme sector and stock performance dispersion can be seen not only in the outperformance of the tech megacaps vs S&P 500 Market Cap Weighted index but also in the underperformance of the S&P 500 Equal Weighted index (up 7.3% YTD) vs the S&P500 Market Cap Weighted index YTD (up 18.4% YTD), with the Equal Weighted index underperforming the Market Cap Weighted index by 10.1% YTD.
Equal Weight vs Cap Weight – what’s the difference?
The key difference between the S&P 500 Market Cap Weighted index and the S&P 500 Equal Weight index lies in how they assign weight to individual companies within the index. The S&P 500 Market Cap Weighted index assigns weights to companies based on their float-adjusted market capitalisation, thus larger companies with higher market capitalisation will have a more significant impact on the index’s performance. Investing in the S&P 500 Market Cap Weighted index can be viewed as a momentum trade as the index over weights larger companies that are growing. The S&P 500 Equal Weight index assigns all companies in the index an equal weight, regardless of their size or market capitalisation, thus each company contributes equally to the index’s overall performance irrespective of its market capitalisation. This could potentially lead to better diversification across market segments. Investment in the Equal Weight index can be seen as a value or contrarian trade as rebalancing back to target ensures that profit is taken on shares that have outperformed and increases the allocation to shares that have underperformed in the period (buy low, sell high).
Historic performance?
While the S&P500 Market Cap Weighted index has outperformed this year, this is not always the case. In fact, if one looks at longer periods (20 years plus) the Equal Weight Index has outperformed.
One argument put forward for Equal Weight index outperformance is the value trade or the inherent buy low, sell high characteristics. Another argument is that the smaller stocks in the index are more likely to outperform larger stocks given the skewness of their performance distribution. As the Equal Weight index assigns greater weights to smaller stocks, this index should outperform over the long run.
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Conclusion
Whether the above arguments hold, will continue to hold and are sufficient to conclude that investment in the Equal Weight index in place of the Cap Weighted index will give you better returns over time, is up for debate. However, understanding the construction of these indices and the inherent characteristics of each index is a valuable investment tool that can be used to an investors advantage as it allows an allocation to a broad index (gaining broad diversified exposure and avoiding single stock concentration risk such SVB, Signature Bank and First Republic Bank) coupled with either a value or momentum play (which may be more appropriate in different parts of a market cycle). Given the significant outperformance of the megacap stocks (which has in turn driven outperformance of the Market Cap index from March 2023) it may be time to consider taking profits and rotating towards the Equal Weight index, increasing allocations to smaller stocks with currently lower valuations.
At Omba we are Exchange Traded Funds (ETFs) specialists who understand the nuances of using ETFs to build globally diverse investment portfolios. Our process and expertise ensure that we shift exposures between asset classes, countries, sectors, themes, and factors (including value and momentum factors) depending on the market environment. The use of ETFs to build globally diversified portfolios gives investors access to diversified market beta (with no single stock risk) and allows for macro investment decisions/allocations which aim to add alpha over the long run.
