The Case For Equal Weight Indexing

2020 witnessed outperformance from some of the largest S&P 500® companies as investors expected these firms to be better placed to navigate the COVID-19 environment. Exhibit 1 shows that this outperformance led to the largest names accounting for an unusually high proportion of the U.S. large-cap equity benchmark, and therefore having a bigger impact on the index’s returns. For investors looking to gain large-cap exposure with lower sensitivity to the biggest names, and potentially to take advantage of reductions in market concentration, Equal Weight may be worth considering.

Launched in January 2003, the S&P 500 Equal Weight Index weights each S&P 500 company equally at each quarterly rebalance. Exhibit 2 shows the historical benefit from applying this weighting scheme within U.S. large caps; the S&P 500 Equal Weight outperformed since its launch as well as over its lengthier, back-tested history. Rather than being strictly a U.S. phenomenon, the outperformance in Equal Weight indices has been observed globallyincluding in Japan.

One of the key perspectives in explaining equal weight indices’ returns is their smaller size exposure: for example, over 50% of the historical variation in the S&P 500 Equal Weight Index’s relative returns is explained by size.This exposure occurs because, as Exhibit 3 illustrates, the distribution of weights within equal weight indices is far more even than within their market-cap weighted parents. For example, the S&P 500 Equal Weight Index is far less sensitive to the performance of the largest names in the market and offers more exposure to smaller S&P 500 companies.

Equal weight’s smaller size exposure helps to explain the link between market concentration and equal weight’s relative returns. All else equal, if the largest companies (to which equal weight has less sensitivity) outperform, concentration rises, and equal weight is likely to underperform its cap-weighted benchmark. Conversely, outperformance among smaller companies (to which equal weight has greater allocations) leads to reduced concentration and the likelihood of equal weight outperformance.

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