ETF Specialist

This Index Fund Breaks the Link Between a Stock's Price and Its Portfolio Weighting

Adam McCullough, CFA

Passive investors can leverage the collective wisdom of active investors by market-cap-weighting the holdings of an index. A stock's weighting in a market-cap-weighted index moves with its share price. The knock on market-cap-weighting is that it could lead to single-stock and sector concentrations in the most expensive parts of the market. Equal-weighting the stocks in an index attempts to bypass this possible tilt toward expensive names by severing the link between a stock's portfolio weighting and its price.

 Invesco S&P 500 Equal Weight ETF (RSP) effectively delivers mid-cap stock exposure by weighting the stocks in the S&P 500 equally instead of by their market cap. This approach increases the fund's exposure to the smaller and riskier stocks in the S&P 500. Equal-weighting diversifies firm-specific risk but leads to persistent sector bets that may not always pay off. The fund's low fee offers a durable cost advantage, but there are market-cap-weighted mid-cap stock funds available for a fraction of the fee. It earns a Morningstar Analyst Rating of Bronze.

The fund tracks the S&P 500 Equal Weight Index, which assigns equal weightings to the stocks in the S&P 500. Because the smallest and largest stocks receive the same weighting, the fund's average market cap measures one fourth that of the S&P 500. This approach increases the fund's risk, and its performance since inception in May 2003 has more closely matched mid-cap rather than large-cap stock index funds.

As a result of the fund's weighting approach, it makes persistent sector bets that won't always pay off. Compared with its Morningstar Category peers and the S&P 500, the fund has higher industrials, real estate, and utilities sector weightings. And the technology sector represents its largest underweighting. Equal-weighting also injects a slight value tilt, because when the fund rebalances each quarter, it trims stocks that have outperformed their peers and adds to names that have underperformed and likely gotten cheaper.

During the trailing 10 years through September 2018, the fund trounced the large-blend category by 4.2 percentage points annually, ranking in the top decile of the category. However, the fund takes more risk than most of its peers because it has greater exposure to smaller stocks, which tend to be more volatile than their larger counterparts. Its risk-adjusted returns (as measured by its Sharpe ratio) landed near the 33rd percentile. The fund's higher risk has paid off, but that won't always be the case. For example, during the bear market from October 2007 through March 2009, this fund cumulatively lost 59.1% of its value compared with 55.0% for the S&P 500.

Fundamental View
Although this fund has "S&P 500" in its name, don't expect the same investment experience as a market-cap-weighted S&P 500 fund. This strategy holds all of the stocks in the S&P 500 but equally weights them. Compared with the market-cap-weighted index, the fund overweights the smallest names in the S&P 500 and underweights the largest names in the index.

This weighting approach has delivered returns that look similar to those of a market-cap-weighted mid-cap equity fund. For example, the fund posted lower tracking error against the S&P MidCap 400 Index than against the S&P 500 from its inception in May 2003 through September 2018. A dollar invested in May 2003 in this fund's underlying index would have been worth $5.61 at the end of September 2018. During the same time period, $1.00 invested in the S&P MidCap 400 Index and S&P 500 would have been worth $5.74 and $4.36, respectively.

Because this fund rebalances its holdings to equal weightings each quarter, it maintains a much smaller average market cap and a slightly contrarian value orientation compared with its market-cap-weighted counterpart. As of this writing, the fund's average market cap of $27 billion measured about one fourth that of the S&P 500. Tilting toward smaller stocks has increased the fund's risk compared with the large-blend category. Its standard deviation for the trailing 10 years through September 2018 measured 17.7 percentage points, landing in the riskiest decile of the category.

The fund's systematic quarterly rebalance also drives its slight value orientation. Stock price movements cause holdings' relative weightings to diverge between rebalancing dates. When the fund rebalances back to equal weightings, it adds to stocks that have underperformed relative to others in the S&P 500 and trims from those that have outperformed. Despite these small size and value skews, the fund lands in the large-blend category.

Breaking the link between stock price and portfolio weighting may help this fund avoid the pitfalls of relying on the market to price stocks, such as periods of mania or panic. Market-cap-weighted funds automatically incorporate new information from stock prices and effectively free-ride active investors' price-discovery process. Ignoring market prices in its weighting approach raises the fund's turnover and transaction costs compared with market-cap-weighting, but the fund's 10-year average annual turnover of 25 percentage points still measures less than half its category average. And the exchange-traded fund structure has helped RSP maintain tax efficiency; it didn't issue a capital gains distribution in the past decade through 2017.

A benefit of equal-weighting is that this fund effectively diversifies firm-specific and sector concentrations. By design, this fund's top 10 holdings represent 2 percentage points of its portfolio compared with 20 percentage points for the market-cap-weighted S&P 500. Company count, rather than size, drives sector allocations. Not surprisingly, the strategy's technology sector weighting differs most from the S&P 500's. As of this writing,  Apple  (AAPL),  Microsoft (MSFT), and (AMZN) cumulatively represented 10.9% of the S&P 500 but only made up 0.6% of this fund at its rebalance.

Portfolio Construction
The fund fully replicates the S&P 500 Equal Weight Index, which invests in the same stocks as the S&P 500 but weights them equally instead of by their market cap. By rebalancing to equal weightings quarterly, this fund essentially provides a mid-cap equity index exposure with higher turnover and transaction costs. It earns a Neutral Process Pillar rating.

Each quarter, this well-diversified fund pares stocks that have outperformed and adds to names that have underperformed, which injects a modest contrarian rebalancing discipline. This approach helps the fund mitigate a potential drawback of market-cap-weighting by avoiding single-stock and sector concentrations. But market-cap-weighted funds' weightings naturally move with their prices, so they're cheaper to implement. Breaking the link between a stock's price and its portfolio weighting increases the fund's transaction costs. A committee determines the S&P 500's holdings, a structure that provides more flexibility than indexes that follow mechanical rules, though this approach also reduces transparency. To be added to the index, potential constituents must have generated positive earnings in their most recent quarter and in aggregate during the most recent four quarters.

Invesco charges a 0.20% annual fee for this fund, which is cheap compared with actively managed funds, but a multiple of the cheapest market-cap-weighted mid-cap equity funds. It earns a Positive Price Pillar rating.

During the past year through September 2018, this fund lagged its benchmark by 23 basis points, slightly higher than its fee. This was likely due to its high quarterly reconstitution, which increases transaction costs compared with market-cap-weighted funds.

Goldman Sachs Equal Weight U.S. Large Cap Equity ETF (GSEW) (0.09% expense ratio) offers nearly identical exposure for half of the price. It equally weights the Solactive US Large Cap Index, which includes the 500 largest companies by count. Unlike the S&P 500, this index is not selected by a committee and includes unprofitable stocks.

Invesco Russell 1000 Equal Weight ETF (EQAL) (0.20% expense ratio) goes a step further than RSP by first equal-weighting each sector and then weighting the stocks within each sector equally. Because it selects holdings from the Russell 1000 Index instead of the S&P 500, this fund reaches further down the market-cap spectrum.

 Schwab Fundamental U.S. Large Company ETF (FNDX) (0.25% expense ratio) weights large- and mid-cap U.S. stocks based on fundamental measures of size. This approach introduces a deeper value tilt compared with RSP and doesn't dip as far down the market-cap spectrum as RSP. Similar to RSP, this fund introduces a contrarian rebalancing technique that allows the fund to efficiently profit from mean reversion in valuations. Instead of rebalancing the entire portfolio each quarter like RSP, this fund divides the portfolio into four slices and rebalances a different slice each quarter, which helps reduce the market-impact costs of rebalancing. This fund earns a Bronze rating.

Gold-rated  iShares Core S&P Mid-Cap ETF (IJH) (0.07% expense ratio) is among the cheapest mid-cap stock funds available. This fund tracks the S&P MidCap 400 Index. IJH has delivered returns similar to RSP's over the long haul, but with lower turnover and transaction costs because it uses market cap to weight its holdings.



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Adam McCullough, CFA has a position in the following securities mentioned above: AAPL AMZN. Find out about Morningstar's editorial policies.