Market Cap vs. Equal Weighted Index Funds - Explained
The differences and the pros and cons of equal-weight indices vs traditional market-capitalisation-weighted
👋🏼 everyone,
Hope you’re all having a good week.
At the time of writing this, the S&P 500 ($SPX) is up +24.2% year-over-year.
And when you look at the equal weighting performance of the S&P 500, then it’s up +11%.
However, it dawned on me as I was checking these figures that even if you want to stick to a simple strategy like passively buying an S&P 500 index fund, then you’ll still be confronted with some options because there’s more than one way to invest:
The market-cap-weighted S&P 500 (which is the default for ETFs like VUSA or VOO)
The equal weight S&P 500 (which is what some people recommend)
So with that said, let’s dig a bit deeper.
Today’s talking points:
Market cap and equal weighted, quickly explained
Potential upsides and downsides of both options
But doesn’t market-cap always outperform? (short answer, no)
Where you can find the weighting information for a index fund
(Quickly) Explained…
What is a market-cap weighted index
Before I get into market-cap weighted index, let’s first quickly explain market capitalization.
Simply put, it's the market price of the entire company.
When people buy shares, they know they are buying a piece of the company. So it makes sense the worth of the entire company is the share price multiplied by the number of shares.
An example
If a company is divided into 1 million shares and the share price is $5 then the market cap of that company is $5 million.
Now back to a market-cap weighted index…
It is a compilation of stocks like the S&P 500 which you can find more about here.
Basically, you invest money into a basket of stocks.
A higher percentage of your investment goes to each company depending on its size i.e. it’s market cap.
If you were to invest in the S&P on 17th June, 2024, approx. 7% of your dollar would purchase Microsoft, 7% would purchase Nvidia and 6.8% would purchase Apple.
These are the three largest components of the S&P 500 index.
.01% of your dollar would go to smaller S&P 500 companies such as Paramount and News Corp.
What is an equal-weight index?
This is an index that holds all of the companies in an index at a fixed rate.
If you were to invest in an equal-weight index tracking the S&P on June 17, 2024, .2% of your dollar would purchase Microsoft, .2% would purchase Nvidia, .2% would purchase Paramount and Newscorp as well.
As an investor, why should you care?
As a investor in index funds, the decision between an equal-weighted index fund and a market-cap-weighted index fund boils down to how you want your investment pie sliced up and how you might view risk.
Market-cap-weighted index funds allocate more money to companies with higher market values, meaning that larger companies get a bigger slice of your investment.
In very simple terms, right now if you’re invested in the market-cap S&P 500, then you’re placing a bet that the tech sector giants e.g. Nvidia, Apple, Microsoft etc, making up by far the largest share of the pie, are going to continue to perform well.
The benefits of market-cap-weighted funds include efficiency and lower costs.
These funds naturally lean towards the biggest players in the market, which are often stable and well-known companies, reducing the need for frequent rebalancing and thereby lowering management fees.
However, this also means your investment is heavily skewed towards these larger companies. If these big players stumble, your fund might take a significant hit.
Also, you might miss out on growth opportunities from smaller or mid-sized companies that could be the next big thing.
On the other hand, equal-weighted index funds give the same weight to each company in the index, regardless of size.
This method provides more diversification by spreading your investment more evenly, reducing the risk associated with any single company’s poor performance.
Additionally, it gives you better exposure to growth opportunities from smaller companies, which have more room to grow. This said, equal-weighted funds come with higher costs due to the need for regular rebalancing to maintain equal distribution, which leads to higher management fees.
They can also be more volatile, as smaller companies tend to experience more ups and downs in their stock prices.
As I said, you need to consider your risk tolerance.
If you’re more comfortable with stability and prefer not to worry about frequent fluctuations in your investment, market-cap-weighted funds might suit you better. Conversely, if you’re willing to accept more volatility for the potential of higher returns, equal-weighted funds could be more appealing.
Secondly, think about your investment goals.
Market-cap-weighted funds are easier to manage and might be preferable if you’re looking for steady growth with less hassle.
If you’re aiming for higher potential returns and are okay with taking on more risk, equal-weighted funds could be the way to go.
Finally but importantly, consider your market outlook. If you believe that smaller companies or less dominant sectors are going to outperform the big players in the coming years, equal-weighted funds provide more exposure to these potential winners.
Ultimately, your choice boils down to how you balance your desire for stability against your appetite for growth. It’s like deciding between a dependable, smooth ride and a potentially exciting but bumpier journey.
Where you can find the weighting information for a index fund
OK, so let’s use two real examples.
First up, let’s look at one of the most popular funds tracking the S&P - Vanguard S&P 500 ETF (Ticker: $VOO). On your broker platform, you’ll see something which is typically described as portfolio composition or holdings, that will show you the breakdown of the fund.
As you can see this fund is not equally weighted, it’s a market-cap driven fund
Now let’s look at another version, which is an equal weighted fund (which you’ll notice from the holding information) - Invesco S&P 500® Equal Weight ETF
Thank you very much for reading 🙏 if you found this helpful and enjoyed the post, I’d be super grateful if you could hit the ❤️ below - thank you!
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DISCLAIMER: None of this is financial advice. Concepts of Finance newsletter is strictly for educational purposes.
When you look closely at standard index funds, you realize that growth comes from just a handful of companies.