Market capitalization (or market cap-weighted) funds weight each holding according to its respective market-capitalization size. Market capitalization is the total dollar value or financial size of a company. The stocks with higher market capitalizations will have the greatest weights, which leads to these holdings having more influence on overall performance.
Although market cap-weighted index funds are the most common form of index funds, investors are continuing to seek alternative strategies in an attempt to enhance returns. Here, we discuss the approach known as equal-weighted indexing.
Equal-weighted funds assign equal weightings to the holdings within the index, regardless of the company size. Therefore, the smallest and largest companies receive the same weighting. Each holding within an equal-weighted fund can have a similar impact on the performance.
There are numerous examples of market cap-weighted indexes that have been made into equal weight strategies: the S&P 500, the Russell 2000, NASDAQ and even sector specific indexes (financials, information technology, etc.).
The SPDR® S&P 500 ETF (SPY) is a market cap-weighted index fund focusing on the S&P 500 index. The Guggenheim S&P 500 Equal Weight ETF (RSP) is an equal-weighted index fund focusing on the S&P 500 Equal Weight Index. Equal-weighted funds by nature tend to have more exposure to smaller large-cap companies and mid-cap companies, which may have higher growth potential in the long run. This may result in slightly higher fund volatility.
Exhibit 1 highlights the differences between (SPY) and (RSP) in terms of the weight in each of the represented company stocks. As can be seen, the top five holdings in SPY account for over 10 percent of the entire portfolioand as a result will greatly impact the performance.
Exhibit 1 also shows that the top five holdings in RSP account for only 1 percent of the portfolio. The top five holdings are far more impactful to the performance of the market cap-weighted fund.
The difference in these two strategies results in varying sector exposure. For equal-weighted funds, like RSP, the sector weights are driven by the number of companies in each sector rather than their market value. For investors with a significant number of holdings in certain sectors, it may be prudent to note the differences between an equal-weighted fund and a market cap-weighted fund for diversification purposes. For example, the information technology sector is more represented in the market-cap SPY fund (21.7percent) than it is in the equal-weight RSP fund (14.0 percent).
Equal-weighted funds by nature tend to have more exposure to smaller large-cap companies and mid-cap companies, which may have higher growth potential in the long run. This may result in slightly higher fund volatility.
Although the underlying stocks in a market-weighted and equal-weighted fund could be the same, the different weightings for each stock can lead to two different acting funds. Depending on investors’ objectives, they may find both types of index funds helpful in complementing their portfolios. For help identifying the appropriate strategy, individuals should consult with a financial advisor.
This article was originally published in the May–July 2017 issue of Worth.