By Mark Hulbert, MarketWatch
There’s a simple way to bet on the S&P 500 without also taking the outsized bet on the “FAAMG” stocks that currently dominate the U.S. benchmark index.
FAAMG is the acronym for the five stocks that collectively account for about 20% of the S&P 500’s /zigman2/quotes/210599714/realtime SPX -0.16% valuation: Facebook /zigman2/quotes/205064656/composite FB -0.48% ; Apple /zigman2/quotes/202934861/composite AAPL +0.75% ; Amazon.com /zigman2/quotes/210331248/composite AMZN +2.15% ; Microsoft /zigman2/quotes/207732364/composite MSFT +0.0047% , and Google (Alphabet) /zigman2/quotes/202490156/composite GOOGL +0.01% . When you invest in an S&P 500 index fund, you are effectively betting that these five stocks will do exceedingly well.
These five stocks have such an outsized share of the S&P 500 because the index is cap-weighted; a component stock’s weight is a function of its market capitalization. If the S&P 500 was equally weighted, then these five stocks together would represent exactly 1% of the index (0.2% x 5).
To bet on the S&P 500 without also betting so heavily on the FAAMG stocks, what you need to do is invest in the equal-weight version of the index. An ETF that is ready-made for this purpose is Invesco S&P 500 Equal-Weight ETF /zigman2/quotes/202854823/composite RSP -0.74% .
Weighing the differences
So far this year, index fund investors’ implicit bet on FAAMG has paid off: these stocks’ average year-to-date total return is over 40%, versus 8% for the S&P 500. And the index return itself has been skewed upwards by the outsized weight in those five stocks. By contrast, the equal-weight ETF has lost 1.3%.
This year’s experience appears to be more the exception than the rule, however. Since the equal-weight S&P 500 ETF was launched in April 2003, it has beaten its cap-weighted rival, SPDR S&P 500 ETF Trust /zigman2/quotes/209901640/composite SPY -0.15% by a margin of 10.5% to 10.1%, annualized.
Though I don’t have any real-world performance data prior to April 2003, S&P Dow Jones Indices has calculated back to the early 1970s the theoretical return of the benchmark itself. Since the end of 1970, as you can see from the chart below, the equal-weight version has outperformed the cap-weighted S&P 500 on a total return basis by 1.4 annualized percentage points: 12.1% versus 10.7%. (The margin by which this index beat the S&P 500 is larger than the margin by which the RSP beat the SPY, primarily because transaction costs and management fees weren’t included in the calculation.)
Both the performance of the RSP, as well as that of the index itself back to 1970, force me to modify what I said when I last wrote about the difference between equal- and cap-weighting. I wrote that “the equal-weighted version of the S&P 500 will lag the market over time.” What I now want to say is that, on a risk-adjusted basis, the equal-weight version will match the return of the cap-weight version over time.
Weighing the risks
As my revised comment suggests, it’s important to take risk into account when comparing these two weighting schemes. That’s because the equal-weight version is riskier than the cap-weight version. Since the stock market has risen over time, it’s hardly a surprise that the equal-weight version has come out ahead on a raw, unadjusted basis. That also means you’re comparing apples with oranges when comparing the two versions’ raw returns. Once you adjust for risk, the equal-weight version does not come out ahead.
To illustrate, consider that the equal-weight ETF (RSP) since inception in 2003 has been 17.9% more volatile than the cap-weighted S&P 500 (SPY). If you were willing to incur 17.9% more volatility risk, you could have increased your investment in the SPY by 17.9% — going on margin to that extent, in other words. Had you done that, your return would have come out slightly ahead of the RSP (even after paying margin interest costs to your broker).
This is exactly what the respected Capital Asset Pricing Model (CAPM) would have predicted. The RSP’s greater return is compensation for its greater risk. On a risk-adjusted basis it’s no better. This means that, theoretically, you should be indifferent between the two versions.
What does that mean if you don’t want to be so heavily exposed to the FAAMG stocks and therefore prefer the equal-weight version? While your near-term return will depend on the relative performance of those stocks, the CAPM predicts that your long-term return will be no better or worse than the cap-weighted version on a risk-adjusted basis. So the CAPM in effect says “go right ahead.”
Note carefully that because the equal-weight version is more volatile, you might want to allocate less to it than what you otherwise would invest in the cap-weight version. In order for you to have exactly the same volatility, you would want to allocate to the equal-weight version 85% of what you would otherwise invest in the cap-weight version.