Are Equally Weighted Portfolios Intrinsically Superior To Cap Weighted Portfolios? - A Case Study Using S&P 500 ETFs

Research Affiliates and Dimensional Fund Advisors have been among the esteemed research and investment firms proclaiming that equally weighted portfolios will deliver superior performance to portfolios weighted by market capitalization also known as cap-weighted. This article explores to what extent that has been true in recent years.

IVV is the iShares S&P 500 Index ETF.RSP, part of the INVESCO family, is an ETF holding the identical 500 stocks but with equally weighted positions. We begin our comparison on January 1, 2004, the first full year that RSP was in existence, and complete the analysis with the end-of-day prices of the ETFs on June 30, 2021. For an investor, these numbers reflect realizable returns. Indexes themselves are not directly investible.

Here is a table with the comparison in compound annualized growth rates (CAGR)

 

IVV

RSP

Since Jan 1, 2004- 17.5 years

10.17%

10.41%

6/2011 - 6/ 2021, 10 years

15.29%

13.86%

6/2016 - 6/2021, 5 years

17.45%

14.59%

6/2018 - 6/2021, 3 years

18.34%

15.17%

6/2020 - 6/2021, 1 year

37.18%

43.98%

So, using S&P 500 stocks, we can see that the equally weighted RSP outperformed by a small amount, 24/100 of a percent or 24 basis points since January 1, 2004.RSP outperformed by a much larger amount in the last 12 months ending June 30, 2020, when value stocks came dramatically back in favor. Outperformance by equally weighted portfolios, however, is not a given. In 10-, 5- and 3-year annualized performance, cap-weighted IVV outperformed equally weighted RSP significantly. 

Let’s take a look at the growth of $10,000 invested from January 1, 2004, through June 30, 2021, illustrated in the following graph.RSP, the ETF owning the equally weighted S&P, grew to $57,012 as compared with $54,886 for IVV, a difference of $2,126 or $172 per year. On the other hand, RSP also had higher volatility and the higher maximum drawdown during the period.

Another problem many investors have with the S&P 500 is concentration risk. The top 10 holdings of IVV constitute 27.5% of the portfolio. Moreover, five of the top seven holdings are in the Computer and Technology Industry. This includes Apple, Microsoft, Facebook, Alphabet (Google’s parent), and Nvidia. The remaining two, Amazon and Tesla, have been called “tech companies in disguise” by a noted market pundit. When you consider that Amazon Web Services has accounted for more than 50% of Amazon’s revenues in recent years and Tesla’s focus on being a pioneer in developing new technologies, it’s easy to understand why. With 25% of the total weight in seven tech-dominated companies, it’s no wonder many strategists feel that a second tech bubble bursting would damage the S&P 500 more than most equally weighted portfolios.  

There are no such concentration concerns for holders of equally-weighted RSP. At quarterly rebalancing and reconstitution, each of its 500 holdings account for 0.20% of the portfolio. Between those times, weights drift with market movements. As of the morning of August 16, its top five holdings were: Paycom Software (0.28%); Albemarle Corp (0,28%); Chipotle (0.27%); Monolithic Power (0.26%) and MSCI (0.26%). The top 10 holdings constituted 2.6% of the portfolio.RSP’s industry sectors are also far more diversified with Computers and Technology constituting less than 16% of its weight as compared with greater than 32% for IVV.  In the past 10 years, the much higher exposure to technology has helped ETFs following the S&P 500 post superior return. But another term for exposure is risk. Therefore, if tech should plummet for an unspecified period relative to the remainder of the market, IVV would plummet further than RSP would. 

A frequent question is “What about the Dow Jones Industrial Average (“the Dow”) that calls itself “The Market’s Measure. Its price history can be tracked for more than 100 years.  Many feel that the methodology, holding positions indefinitely with no set rebalancing periods and low historic turnover is much more reflective of how they manage portfolios than IVV or RSP. The Dow is investible through DIA, originally called Diamonds, an SPDR product managed by State Street Global Advisors (“SSgA”).

Institutional portfolio measurement professionals and the Certified Financial Analysts Society agree that in the modern stock market era, a committee-selected aggregation of 30-stocks is insufficient to represent the performance of the 6,000-plus company stock market. Worse, average uses price-per-share as the numerator to determine weight while stock splits are accounted for only in the denominator to keep the magnitude of the indicator consistent. At best, the Dow is still a somewhat useful daily indicator. Its direction, up or down, agrees with that of the S&P 500 an average of 4.3 days out of 5.Mathematically, it is not truly an index with a common base. Beyond that, considerations for removal and replacement have changed over time, something which affects a small collection of stocks more than a large one. Like an investment portfolio, the weighting system that implicitly lowers the percentage of a holding that splits has no empirical support or investment rationale. Managing such a portfolio requires more trades, generally via customized contribution baskets to prevent capital gains, than a standard market-cap-weighted portfolio. 

Despite these myriad reasons serious investors should ignore the Dow, it is still “the market” in the eyes of the majority of investors. Therefore, I include it in the remaining analytic charts and tables. Using the same growth of a $10,000 investment in 2004 methodology, a DIA investment would have grown to $49,990, about $7,000 less than an investment in RSP and $5,000 less than IVV. From this graph, DIA appears to track RSP a bit more closely than IVV. 

This shows pertinent statistics for each ETF. Most of the data are from ValuEngine reports dated August 16, 2021. Provider Fact Sheets used to fill in.

 

RSP

DIA

IVV

ValuEngine Rating

3

3

3

1-Yr Forecast Return

-4.4%

-4.0

-3.7%

1-Yr Historical Return

40.4%

27.2%

32.4%

3-Yr Historical Return

15.5%

13.6%

18.3%

5-Yr Historical Return

12.6%

13.1%

14.3%

10-Yr Historical Return

14.0%

13.7%

15.4%

Volatility

17.8%

16.6%

15.1%

Sharpe Ratio

0.71

0.84

0.94

# of Stocks

500

30

500

% Labeled

Undervalued by VE

36%

23%

36%

VE Beta

1.14

1.00

1.00

VE Alpha

0.00

-0.04

0.00

P/B Ratio

3.5

4.5

4.7

P/E Ratio

25.6

18.6

33.6

Div. Yield

1.3%

1.6%

1.3%

Exp. Ratio

0.20%

0.16%

0.03%

Index Provider

S&P Dow Jones Indexes

S&P Dow Jones Indexes

S&P Dow Jones

Indexes

Index

Scheme

Equally Weighted – Rebalanced Quarterly

Share-Price Weighted

Mkt. Cap Weighted

ETF Sponsor

Invesco

SPDRs by SSgA

iShares by Blackrock

Salient observations we can make:

  1. The investment thesis that over long periods equal-weighted portfolios will outperform market-cap-weighted portfolios is not validated by performance during the past 10 years. In 3-, 5- and 10-year periods, IVV provided higher rates of return than RSP with consistently less volatility.
  2. The prior 7 years from 2004 through 2010 was more supportive of the thesis lifting the 17.5-year return of RSP to slightly higher than that of IVV, indicating that the outperformance of RSP during those 7 years was greater than 150 basis points during that period. 
  3. The equally weighted S&P provided less expensive valuations in terms of Price/Book and Price/Earnings Ratios at each measuring point used in the study. This reflects one reason why active managers tend to prefer equally weighted portfolios. The DIA has the highest dividend yield of the three although all three are near historic lows.
  4. With an ultra-low 0.03% expense ratio, IVV has been a true bargain during the past 10 years with returns higher than 75% of actively managed mutual funds measured by the SPIVA (S&P 500 Index vs. Active study). 
  5. Alternatively, the 20 basis points charged by RSP is more than 6 times higher. However, it is still relatively low compared to most ETFs based on specialty indexes and certainly an affordable alternative to active management.
  6. Those worried about technology sector concentration risk currently embedded in the S&P 500 have a solid alternative in equally weighted RSP. It has delivered highly competitive returns since its launch.
  7. Unfortunately for those looking “to sleep well”, RSP should not be considered a defensive play. During S&P 500 downturns of more than three months, RSP fell more than the IVV all but once during this study. For an equity ETF highly likely to make money when the market goes up and lose less than IVV during significant downturns, check out FSTA, the Fidelity Consumer Staples ETF, discussed in this space twice in the past two months for its resilient defensive characteristics. 
  8. Diamonds is a very sexy name for an investment vehicle. However, the Dow is much better suited for referencing US market movements over long periods of time than it is as an investment vehicle. There are much better alternatives for most investors to DIA.

Getting back to the article’s title question, the answer is “it depends.”During the past 95 years for which we have S&P 500 history, different economic forces have affected different companies and their stocks in myriad ways. Generally, there have been much-analyzed cycles and regimes that dominate before fading. Some return while others reflect phased-out industries or phased-out analytic techniques. As a lifetime “quant”, I assert with confidence that results depend on the time periods and techniques used for measurement. Some of our greatest academics and practitioners have written revered journal articles demonstrating the historical superiority for equal weighting over market capitalization weighting. Many logical reasons have been put forth as to why this is true. But eleven years of cap-weighted S&P 500 dominance makes one question whether this “truth” is still valid. Certainly, the rates of return during the past 11 months provide evidence that the market is returning to the historical dominance of equally-weighted portfolios. I counter that the market is dynamic. The Internet era has all but eliminated the wide gulf of systematic disintermediation of information relating to stock market performance and the superior historical efficacy of index funds to active management. That knowledge is one of many dynamic factors continuing to change investors’ behaviors. 

Which weighting system is superior? I’ll stick with “It depends.”The good news is that both IVV and RSP are very reasonable holdings as core portfolio ETFs. 

Disclaimer: Always read the fact sheets and/or summary prospectus before buying any ETF.  Past performance is not necessarily indicative of future results.

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Comments

Dick Kaplan 2 years ago Member's comment

Good article. I'm a fan of equal weighting.

Anne Davis 2 years ago Member's comment

Thanks for the read.

Herbert Blank 2 years ago Contributor's comment

You are welcome.  Very kind of you to say.