Over more than 20 years of live history, the S&P 500^® Equal Weight Index has outperformed the S&P 500 by a substantial margin. Between Dec. 31, 1990, and June 30, 2023, Equal Weight’s compound annual growth rate was 11.82%, well ahead of the cap-weighted S&P 500 at 10.55%. This performance edge is a product of robust underlying characteristics, most importantly a tilt toward smaller-capitalization stocks. Equal Weight’s historical returns have outpaced those of virtually every active large-cap U.S. equity portfolio in our SPIVA^® database.

But the candid observer must recognize that Equal Weight’s performance advantage does not accrue smoothly. Exhibit 1 plots the ratio of performance between Equal Weight and the cap-weighted S&P 500. When the line in Exhibit 1 is rising, Equal Weight is outperforming; a falling line indicates cap weight outperformance.

As the exhibit suggests, there can be long periods of both under- and outperformance. For example, Equal Weight lagged for more than five years between August 1994 and February 2000, and then began a six-year run of superior returns.

We need not look so far back in time to find examples of market rotation between Equal Weight and cap weight. In calendar 2022, Equal Weight outperformed the S&P 500 by 6.7%; in the first six months of 2023, Equal Weight lagged by 9.9%. Exhibit 2 shows the difference between Equal Weight and cap weight over a trailing six-month horizon.

The median difference, measured over all six-month intervals, was 0.59%. Exhibit 2 makes it clear that when the series is well above that level, it tends to decline; when well below that level, it tends to increase. As of June 30, 2023, the trailing six-month difference was -9.86%, which ranks at the 2^nd percentile of all observations. If the historical distribution of returns is a fair representation of the future distribution, this means that the Equal Weight – cap weight spread is far more likely to rise than to fall. Remember Stein’s Law: “If something cannot go on forever, it will stop.”

But when? I would tell you if I knew, but like so many issues in investment management, agnosticism is the most prudent response. Nonetheless, the data do tell us something important about the speed with which market trends can reverse.

The worst six-month interval for the relative performance of Equal Weight ended with the technology bubble in February 2000, as Equal Weight lagged the S&P 500 by 10.79%. The best six-month interval for the relative performance of Equal Weight ended in February 2001, when Equal Weight outperformed by 20.04%. The gap between the worst and the best readings in our 32-year history was only 12 months. An advisor who reduced his Equal Weight holdings in 2000 because of then-disappointing performance would probably have found it even more disappointing to miss the subsequent reversal.

Successful asset management sometimes requires holding positions when one’s natural instinct is to sell. Fortitude is most required when its potential benefit is great.

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