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Index investors are facing a quandary this year after the strong rally in artificial intelligence-related stocks left the S&P 500 dominated by a handful of massive technology companies: Do you stick with an index that looks top-heavy?

Traditional index investing, which generally weights companies based on the total value of their shares – or market capitalization – has long held appeal.

Numerous studies, including frequent reports from Standard & Poor’s, highlight the poor track record of most actively-managed mutual funds, which fail to outperform major indexes over the long term after fees are deducted.

Investing in a low-fee exchange-traded fund is an ideal solution: You’re not making bets on individual stocks, but rather accepting that a benchmark will reflect the collective wisdom of all investors. It’s hard to beat the index with stock-picking.

The problem? The S&P 500, the world’s go-to benchmark for U.S. stocks, is looking a bit wacky this year, leading some observers to consider alternatives to traditional indexing.

The S&P 500 gained 16.9 per cent during the first half of 2023. But the breadth of the rally – or the number of stocks that contributed to the gains – was the narrowest in history for the first half of a year, according to Savita Subramanian, equity and quant strategist at Bank of America.

Blame Big Tech: The shares of the five biggest companies in the S&P 500 – Apple Inc. (AAPL-Q), Microsoft Corp. (MSFT-Q), Google-parent Alphabet Inc. (GOOG-NE), Inc. (AMZN-Q) and Nvidia Corp. (NVDA-Q) – have risen 75 per cent in 2023, on average. Together, these stocks account for nearly a quarter of the index in terms of their weightings, the highest level of concentration in about 50 years.

A bet on the S&P 500 is increasingly becoming a bet on these five AI-fuelled stocks, which come with lofty valuations. Nvidia, for example, trades at more than 220 times trailing earnings.

Ms. Subramanian’s recommendation: Own the equal-weighted version of the index for the second half of the year.

This approach gives investors access to all the stocks in the S&P 500 in equal slices, so that no stock dominates. Through equal weighting, Alaska Air Corp. and Campbell Soup Co. (CPB-N) have as much influence as Apple and Microsoft.

More investors appear to like this approach. According to analysts at CIBC World Markets, interest in the Invesco S&P 500 Equal Weight ETF (RSP-A) (EQL-F-T) has surged in recent weeks. Since May 15, the ETF has attracted net inflows of US$4.8-billion, or about 15 per cent of its assets under management.

One of the benefits of equal weighting: If the bull market broadens so that more stocks participate, or interest in AI falters, investors will be better off.

Another benefit: long-term returns. The 20-year average annual return of the equal-weighted index is 11.5 per cent, as of April 30, 2023, according to S&P. That beats the 10.3-per-cent return for the market-weighted version of the S&P 500 over the same period.

“Equal weighting historically has a better track record,” Lyn Alden, of Lyn Alden Investment Strategy, said in an e-mail. The approach tends to give greater emphasis to so-called quality stocks with stable earnings and low debt.

However, the equal-weighted version of the S&P 500 has underperformed this year by nearly 10 percentage points. If AI continues to captivate investors, and the likes of Nvidia, Microsoft and other tech behemoths widen their lead over the rest of the market, equal weighting will lag.

ETFs tied to equal weighting also tend to cost more in fees, given the frequent rebalancing required to maintain the proper weightings. The Invesco fund charges a management expense ratio of 0.2 per cent – not a lot, but more than five times what a typical S&P 500 ETF will cost.

The bigger issue facing investors: In choosing an equal-weighted approach to the S&P 500, are they diverging from the concept of indexing?

Ms. Alden doesn’t think so. Weighting stocks based on market capitalization is the original approach to indexing, she said, simply because it’s cheap and has the lowest turnover of stocks. But equal weighting, she added, “doesn’t mean investors are abandoning the principles of indexing.”

Tim Edwards, managing director and global head of index investment strategy at S&P Global, said that with an equal-weighted approach, investors are doing something different to just following the total market. But it’s a reasonable move: AI valuations could tumble, the outperformance of tech stocks could ease, and the rest of the market could catch up as breadth increases.

“Those would be perfectly sensible reasons to prefer an equal-weight approach to a market cap approach in the short term,” Mr. Edwards said.

The question is whether AI, which drove returns in the first half of the year, will surrender to the likes of Campbell Soup.

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Tickers mentioned in this story

Study and track financial data on any traded entity: click to open the full quote page. Data updated as of 12/04/24 3:55pm EDT.

SymbolName% changeLast
Apple Inc
Microsoft Corp
Alphabet Inc. Cdr [Cad Hedged]
Nvidia Corp
Campbell Soup Company
S&P 500 EW Invesco ETF
Invesco S&P 500 Eql Weight Idx ETF Hgd

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