Did you think that there was just one type of the S&P 500 Index? Well if you did you are wrong.
In this blog post, I am going to give you the low down on three different types of S&P 500 indices (Market Cap Weighted, Equal Weighted and Reverse Cap Weighted) and along the way we will try to work out that is the best option for you.
What’s the difference?
Market Cap Weighted
The market capitalisation weighted Index of the S&P 500 is generally what people refer to when they ever bring up the S&P 500 in conversation or on the financial news.
Not all companies in the S&P 500 are equal, you have ginormous companies such as Amazon with a market cap of €1.16Trn and also companies such as Delta Airlines which have a market cap of $20bn which is still pretty big but not on Amazon’s scale.
Holdings in the market cap-weighted index are apportioned based on company size, with larger companies (in terms of market cap) being given a bigger weighting in the index.
For example, at the time of writing Apple has a weighting of 6.94% of the makeup of the S&P 500 even though it is just one company our of 503 listed in the index. Other companies that make up a big chunk of the index are Microsoft (5.56%), Google (6.79%), Amazon (3.15%) and Tesla (1.18%).
As many of the largest American companies are Tech-focused, the S&P 500 is weighted much more towards the Tech industry rather than industries such as Health, Energy, etc.
Tech makes up 26.07% of the Index ( as of Sept 2022), while consumer staples just make up 6.88%.
Equal Weighted
Instead of having a couple of big companies dominate the index, the equal-weighted index gives each of the 503 companies listed on the S&P 500 index an equal holding.
This means that if you invest in an ETF that tracks the S&P 500 equal-weighted index your portfolio will hold approximately 0.20%-0.25% of each of the 503 companies.
The equal-weighted index is far more balanced when compared with the market cap-weighted index. Tech stocks will just make up approximately 15% of your holdings compared to 26% in the market cap-weighted index.
Note that this index rebalances quarterly. The impact of this for a fund manager tracking the index will be that they need to sell the investments that performed well in the quarter and increase the holdings of poor performers to regain the fixed equal weighting.
Reverse Cap Weighted
Lastly, there is another version of the S&P 500 that not many people are not familiar with – the revere cap-weighted index. This flips the logic of the regular market cap-weighted index by instead applying the the greatest weighting to the companies with the lowest market cap (1/Mkt Cap).
What is the idea here you might ask? Markets are inefficient, their is a tendency of for the S&P 500 to place to much weight on overvalued companies such as Tesla, that have huge P/E ratios.
The reverse cap-weighted index allows investors to take a position that the market will eventually correct. Undervalued companies will get repriced to their fair value, whilst overvalued companies will also see large price corrections.
Which Index has performed the best historically?
Although we are looking at a small sample here we can get an idea of how each one performs depending on the market conditions.
| YTD (Sept 22) | 1 Year | 5 Years | |
|---|---|---|---|
| S&P 500 (Market Cap-Weighted) | -22.4% | -17.69% | 44.45% |
| S&P 500 (Equal Cap-Weighted) | -19.63% | -16.1% | 32.6% |
| S&P 500 (Reverse Cap-Weighted) | -19.86% | -17.52% | 6.17% |
All three indices are down significantly in 2022 as no asset has escaped devaluation with the rapid rise in interest rates by the FED to combat the inflation crisis.
However, the market-cap-weighted fund was the worst hit, down 22.4% year to date compared to the other indices which were down by approximately 19.6-19.9% over the same time period.
This makes sense as overvalued tech stocks were the worst hit by the interest rate rises and the market-cap-weighted index put the greatest weighting on the tech sector.
On the other hand, if we take a much longer view the best-performing index was the market-cap-weighted index which returned 44.45% over the last 5 years. This outperformed the reverse cap-weighted index almost 8 fold, which makes sense given the market conditions we saw over the past 5 years.
Low-interest rates prevailed over the last 5 years an there was endless money printing by governments all over the world. This fueled the pumping up of asset values, including the stock prices of companies that may have already been overvalued in the first place.
In all scenarios, the equal-weighted fund was middle-of-the-road, a safer less volatile investment that wouldn’t give you the highest return but would also not face as big corrections in market downturns.
How to decide what is the right index for you?
The decision of which index best belongs as part of your investment portfolio will depend greatly on your investing ethos.
Those with a contrarian view will likely seek to invest in funds that track the reverse cap-weighted index fund as they believe that, over the long term, the market will iron out its inefficiencies and undervalued companies will perform better than overvalued companies.
The logic here may be that the companies that are already the largest by way of market cap may have already had their day in the sun, over-hyped, and unlikely to get the best returns.
If you believe that diversification above all else is the key part of your investment strategy then a fund that tracks the equal-weighted index will be the best one for you as it is not overly exposed to any one index of any large-cap company.
On the other hand, if you believe that following the herd is often the best strategy, weighting your investments more toward companies that have already performed well over the past several years then the market cap-weighted index may be the option for you.
Disclaimer: This blog post is for informational and educational purposes only and should not be construed as financial advice.