The Fix The Investments Series
You may have read that indices or ETFs can be cap-weighted or equal weighted, but what’s that mean, and why is that important?
While not always apparent to investors, each approach can deliver very different results and investor experiences.
Cap-weighted
First, “cap” is an abbreviation for capitalization, which means the total value of all outstanding issued shares of a company.
Lets just dive into a real-life example.
Apple has 4,745,398,000 shares issued, or outstanding. The market price at the moment is about $157, so Apple’s total market cap is about $740 Billion. Measured by overall cap value, Apple accounts for over 3.5% of the S&P 500 index (SPX). Now that’s BIG cap!
…so, its disproportionate weight by capitalization size…
With that in mind, if you own one of the S&P 500 capitalization-weighted tracking funds, like State Street’s SPDR S&P 500 tracker, ticker symbol SPY, your portfolio has about 3.5% in Apple.
So, its disproportionate weight by capitalization size. This approach naturally favors larger companies, which may be defined as value companies, rather than growth.
A cap-weighted portfolio will generally offer more predictability and safety to an investor who embraces large, well-capitalized companies, generally in the value phase of their existence. Large caps generally reduce risk in a portfolio but may not return as much as smaller growth companies.
Cap-weight leaning investors typically use SPY for their S&P 500 proxy.
Equal-weighted
Equal weighting in a portfolio means that you have equal dollar amounts invested in each stock, regardless of the stocks capitalization. If there are 100 stocks in a $10 million portfolio, then each stock position is $100,000. Bigger companies have the same dollar amount as smaller companies in the index.
So, its equal weight by dollars. This approach favors large and small companies equally.
If SPY were an equal weighted ETF, instead of cap-weighted, then you would have only 0.0020% (1/500) of your money invested in Apple, instead of 3.5%. But not all ETFs are equal weight like SPY.
The S&P 500 Equal Weight Index has been around for a little over 15 years. Its constituents are the same 500 companies as the standard S&P 500 composite index, but it is weighted equally by dollar amounts rather than by capitalization.
…so, its equal weight by dollars…
Market research and history has shown us that smaller companies exhibit greater growth potential than their well-established large counterparts.
Equal-weighted portfolios will then have a larger representation of smaller companies with brighter prospects for future growth, but they also have the higher risk profiles as well.
The S&P 500 Equal Weight index ticker symbol is SPW. Invesco S&P 500 Equal Weight ETF, ticker symbol RSP, tracks the SPW, and appeals to proponents of the equal weight school of investing since the small companies have a greater impact on the overall portfolio than in the cap-weighted SPY.
Which is better? To compare results, in the 10 year period from 1/18/09 through 1/18/19, SPY returned 14.55% average annual return, and RSP showed 16.01% average annual return, a difference of 1.46% extra per year in favor of the equal-weight method. Was the extra return worth the risk? Maybe. Maybe not.
Neither approach is inherently better, but the approaches are quite different, and each offers its own set of pro’s and con’s. The choices you make rest solely on your individual investor behavior, objectives, and how you tolerate risk, your desired reward and cost parameters.
Volatility, portfolio turnover and costs will play into every decision you make as an investor, including which weighting method appeals to your sense of intelligent objectives-based investing.
Intelligent investing is most successful when you start investing early in life, do not attempt to time the markets, remain invested through lots of good and bad market cycles in passive index investments, and keep your tinkering to a minimum, preferably only to reallocate asset classes at stated intervals in time.
And always remember to keep an eye on your weight!