Equal-Weight vs Market-Cap Weight

Posted by Sun on August 17, 2007
Post viewed 990 times, 2 so far today

Advertisements

The S&P 500, as well as most of mutual funds and ETFs that track the benchmark, is a market-cap weighted index. This means the weights of the index’s components are determined based on their market capitals. The larger a company’s market value, the heavier the weight in the index. As a result, according to IndexArb.com, the largest 20 companies in the S&P 500, including mega-cap companies such as ExxonMobil, GE, Citigroup, Microsoft, AT&T and Bank of America, etc., contribute to more than 30% of the index (only floating shares are used in calculating the weights in September 2005). Currently, large-cap stocks make up nearly 90% of the index, while the reset are mid-cap stocks. The smallest components, Circuit City and Dillard’s, have only $1.8B in market capital.

Another way to construct the index is, instead of assigning weights according to the stock’s market capital, to give each component the identical weight, thus the equal-weight index. For the S&P 500, since big companies carry much more weights than smaller ones, any dramatic price change of the big names will have a significant impact on the index, though the number of companies involved could be very small. On the other hand, the same change will have a limited impact an equal-weight index as every member shares the same level of responsibility for the index’s movement. Another benefit is, as small- and mid-cap stocks performed historically better than their large-cap counterparts, an equal-weight S&P index could outperform the market-cap weight index in the long term.

Rydex S&P Equal Weight (RSP) is an exchange traded fund (ETF) built based on this equal-wight theory. The following is a chart comparing RSP and the S&P 500 in the past 2 years. According to Morningstar, the 3-year annualized return of RSP is nearly 2% higher than S&P.

In addition, the principle of buy-low-and-sell-high can be well applied to funds tracking an equal-weight index. For example, if a company grows out of proportion, then the fund manager will have to sell shares of the company at highs to maintain the assigned weight. For a member company that’s losing market value, more shares will be purchased when the price is low to keep the allocation. For funds that track the S&P, the opposite will happen.

Then what’s the downside of the equal-weight index? The following is a 1-month chart of RSP and the S&P for the past month. From July 19th to August 15th, the S&P was down 9.47%, but RSP lost 11.05% due to the fund’s 43% share in mid-cap stocks. Looking at the same period, the S&P 400 mid-cap index declined 11.26% while the Russell 2000 small-cap index dropped 11.75%.

Also an equal-weight portfolio should be rebalanced periodically, resulting higher turnover ration. This can be seen from RSP’s 15% annual turnover ratio as compared to SPDRs’ (SPY) 4%.

If you enjoyed reading this post, please consider subscribing to my full RSS feed (What's RSS feed?). Or you can also choose to have free daily updates delivered right to your inbox.

Featured Financial Products

Get the most out of your money with these online banks that pay top interest rates: EverBank: 4.75% APY, FNBO Direct: 3.50% APY, WTDirect: 3.31% APY.
Feeling the pain at the pump? Find out how you can get up to 5% cash back with these gas rewards credit cards. It's the money you have to spend anyway. Why not get some back?