Here’s a Couple of Reasons to Equal Weight the S&P 500

Will Ashworth - Barchart - Tue May 30, 2023

Year-to-date, the S&P 500 is up nearly 10%. Through May 30, 2022, it was down almost 13%. The index’s 23 percentage point relative turnaround from last year’s first half is good.

However, when you compare the index’s performance in 2023 with its equal-weighted cousin, the S&P 500 Equal Weight Index, you realize that the gains made by the S&P 500 this year are highly illusory.

Here are a couple of reasons you should bet on the equal-weight index over the second half of this year.

The Power of a Few

The Globe and Mail’s Scott Barlow, the newspaper’s market strategist, reported some great comments from Scotiabank strategist Hugo Ste-Marie highlighting the biggest problem with market cap-weighted indexes such as the S&P 500.

“The S&P 500 year-to-date rally (up 9.5 per cent) is supported by a very limited number of stocks. For reference, 259 stocks are down this year, with the S&P 500 equal-weight index, which represents the “average” stock, trading slightly into negative territory (down 0.4 per cent),” Barlow reported Ste-Marie’s comments on May 30.

“From a tactical standpoint, the S&P 500 13-week outperformance relative to the equal-weight index is getting quite stretched by historical standards. In fact, the 987 basis points outperformance over the last 13 weeks is a three-standard-deviation move and a new record high …”

The Scotiabank strategist goes on to state that the momentum of the FAANGM+ stocks could carry on for some time, noting that the equal weight version was outperformed for the better part of three years between 1998 and 2000.

However, if you look at the performance of the two indexes over the past five years, it’s clear that the S&P 500 has delivered better returns for most of that time. So, the equal weight index hasn’t been outgunned by its cap-weighted cousin in 2023; it’s been outdone over the past 60 months, give or take.

There’s a thing called mean reversion. At some point, it has to take hold. In the meantime, very few stocks are leading the S&P 500’s gains in 2023.

The FAANGM+ Performance

The domination by the FAANGM+ components of the S&P 500 isn’t a new phenomenon. It’s been happening for years.

In October 2021, an article appeared online that stated the stocks of Meta Platforms (META), Apple (AAPL), Amazon (AMZN), Netflix (NFLX), Alphabet (GOOG. GOOGL), and Microsoft (MSFT) accounted for more than one-fifth of the $9.29 trillion market cap of the entire U.S. market.

The article lists each stock’s performance in 2021 and over the past decade. At that point, Netflix was the most significant contributor to the index imbalance. Today, the stock with the best 10-year annualized total return is still Netflix at 27.77%, 14 basis points higher than second-place Apple. Except for Alphabet (13.34%), their 10-year returns are all between 24% and 27.77%.

In 2023, according to Finviz.com, there are 230 stocks in positive territory and 273 down for the year. Of the six, Meta’s got the second-best return behind only Nvidia (NVDA). Amazon is 15th, Alphabet is 23rd, Microsoft is 26th, Apple is 27th, and Netflix is 33rd.

So, there you have it, all six are S&P 500 top performers nearly halfway through 2023. Only Netflix isn’t in the SPDR S&P 500 ETF Trust’s (SPY) top 10 holdings. It sits in the 38th spot.

Now consider the Invesco S&P 500 Equal Weight ETF (RSP), which tracks the index of the same name. Only Meta, Microsoft, and Amazon are in the top 10. But that’s immaterial because the index is rebalanced quarterly at an equal weighting of approximately 0.20%. By the end of June, the stocks above 0.20% are up for the quarter. Those below 0.20% would be down for the quarter.

Should all six fall out of bed in the second half, your losses won’t be near as significant holding RSP rather than SPY.

The Bottom Line

The man behind The Big Picture blog, Barry Ritholtz, wrote a post about the cap-weighted vs. equal-weighted S&P 500 ETFs in late April.

“Let’s use 2 ETFs for our performance comparisons: SPY and RSP,” Ritholtz stated. “Year-to-date, cap-weighted is ahead by 500 bps – 6.6% to 1.5%. But when we look back 3 years, the equal weight has nearly tripled that advantage: 64% to 50%.”

He points out that SPY has a commanding lead of more than 28 percentage points over a decade. Morningstar says SPY’s annualized 10-year total return (including dividends) was 11.84% through May 26, 159 basis points higher than RSP. Over five years, it increased to 228 basis points.

However, if you compare the two ETFs during the tech correction in 2022, the equal-weighted ETF had a negative total return of 11.62%, 655 basis points lower than SPY—a considerable amount of the difference likely from the FAANGM+ components.

If you think one or more FAANGM+ stocks are overvalued, consider allocating some of your portfolio to RSP rather than SPY. A second-half collapse would most certainly hurt the cap-weighted version more.

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On the date of publication, Will Ashworth did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.