Why an equal weight ETF isn’t just a short-term play

While equal-weighted indices look attractive in the short term, they have a good long-term track record, says Tom Bailey. 

Plenty of articles have recently touted the benefits of exchange-traded funds (ETFs) that track an equal-weighted index. An equal-weighted index holds each company in equal proportion, for example, an equal-weighted FTSE 100 index would have a 1% weighting to each constituent.

We’ve covered the argument for equal weightings in more depth before, but there are three main points. First, the US market, when market-cap weighted, is now hugely concentrated in just a few mega-cap tech stocks. So, for example, half a dozen big tech names now account for almost a quarter of the S&P 500. This means a lot of single-stock risk. An equal-weighted ETF, however, would weight Amazon(NASDAQ:AMZN) the same as the smallest companies in the index.

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Related to this is the fear that the US market is in a late 1990s-style tech bubble, ready to burst. If that is the case, owning the S&P 500 means having a huge concentration in the companies most at risk. Equal weighting, however, brings your tech exposure down and increases your exposure to less frothy parts of the market.

Further related to this, an equal-weighted ETF would position you nicely for an expected rebound in economic activity as the pandemic comes to an end – the so-called reflation trade. An equal-weighted ETF would increase your exposure to less loved parts of the market, mainly cyclical and value stocks, which should benefit from this expected economic boom.

But isn’t this all a bit short-termist? Isn’t deciding now is the right time to switch out of a market-cap weighting to equal-weighting investing based on the news cycle? Investing, we are told, is about being in the market for the long term and letting the gains compound. 

This is a fair criticism but in my view it is worth noting that while equal-weighted ETFs may look like a good investment right now, they may also be a good longer-term investment.

Generally, over the long term, the S&P 500 equal-weighted index has outperformed the market-cap weighted S&P 500. For example, between the start of 1999 and 25 February 2021, the maximum time we have data for both indices, the S&P 500 provided a return of 392.1%, while the S&P 500 Equal Weighted provided 720.9%.  

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That’s a huge difference in return. Of course, starting in 1999 may be a bit unfair, as this means starting almost at the peak of the late 1990s tech bubble. The huge run-up in the share price of tech companies meant that they represented a large part of the index, meaning that the subsequent bursting of the bubble acted as a major drag on the index’s returns.

This is, however, the point: an equal-weighted ETF avoids the investor being overexposed to stocks that have become overvalued or part of a bubble.

However, for argument’s sake, we can use 2003 as our starting point, as by then the tech bubble was largely over. The performance of the market cap weighted S&P 500 definitely starts to look better, with a return of around 540%. However, the equal-weighted index still wins hands down, with returns of just under 710%.

Both data points show that over the long term an equal-weighted S&P 500 ETF, in theory, would have provided higher returns for the investor.

It is fair to point out that this is partly due to the drag the dotcom bubble, and later the 2008 credit crisis, caused. But, as I noted, this is the point: an equal-weighted index protects against overexposure to frothy or bubble-like stocks, which can result in better returns over the long term. If we are facing a late 1990s-style tech bubble, an equal-weight ETF may be good to own for both the short and longer term, using history as our guide.

Unfortunately, long-term data for equal-weighted indices covering other countries is harder to come by. Data for equal-weighted global indices on FE Analytics only goes back to the 2010s, meaning we can’t use it to form a long-term performance picture.

However, the data does suggest that the S&P 500 Equal Weight is perhaps a decent prospective long-term hold, beyond the current short-term arguments for holding it. This index can be accessed on interactive investor using the Xtrackers S&P 500 Equal Weight ETF USD (LSE:XDEW).