Your basic index-tracking exchange-traded fund is one of the greatest investing innovations ever. Buy, hold for decades, build your wealth.
But these index-trackers do have issues, one of which has come to the fore in the stock market rally of the past year. These ETFs use indexes that weigh stocks by market capitalization, which is investment-speak for size. You get a stock’s market cap by multiplying the share price by the number of shares outstanding.
In a bull market, big stocks get bigger and can end up dominating the portfolio of an index-tracking ETF. Example: The S&P 500, an index commonly tracked by ETFs and widely used to measure U.S. stock market returns, was almost 21-per-cent exposed to just five stocks as of March 30 – Apple Inc., Microsoft Corp., Amazon.com Inc., Alphabet Inc. and Facebook Inc.
If these stocks were to soar like they did through much of the past year, an S&P-tracking ETF would do well. But what’s actually happening is that some of these stocks have come off their highs of the past 12 months and weighed down the S&P 500′s results. As a result, the total return for the first two months of the year for this index was a comparatively tepid 1.7 per cent in Canadian dollars.
There’s a way to stay invested in the S&P 500 and avoid this tech-giant dominance. It’s called an equal-weight approach – instead of weighting stocks in the index by their market cap, each is simply given an equal weighting in the area of 0.2 per cent.
The Invesco S&P 500 Equal Weight Index ETF (EQL-T) offers an example of how equal weighting works. It has a 15-per-cent weighting in technology, compared with 27 per cent for the conventional S&P 500. EQL has 10-per-cent exposure to a pair of sectors that could do well as the economy expands – energy and materials. The traditional S&P 500 has about 5-per-cent exposure to those sectors.
EQL’s return for the first two months of the year was 5.1 per cent. For the 12 months to Feb. 28, it was pretty much in step with the S&P 500. For the two years, it lagged by about four percentage points. The reason for EQL’s recent success is that it provides more exposure to value stocks – those that have been undervalued by investors – and less to the high-powered stocks that drove the index last year and now dominate it.
Long-term, a regular S&P 500 index ETF makes great sense as a way to maintain exposure to the U.S. market. Consider the equal-weight approach if you have a shorter-term outlook where you want to keep exposure to stocks but worry about putting money in an S&P 500 dominated by tech stocks that were losing momentum in early spring 2021.
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