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Beating the S&P 500 at Its Own Game

The triumph of the equally weighted index.

Illustrative photograph of John Rekenthaler, Vice President of Research for Morningstar.

Before Its Time

In the 1980s, Dean Witter Reynolds offered a different approach to S&P 500 indexing. Rather than invest by stock market capitalization, thereby making IBM IBM a bigger position than Tyson Foods TSN, Dean Witter’s new fund would invest equal amounts in each of the index’s constituents. Rather grandly, the company named its new offering Dean Witter Value Added Market Series.

The fund greatly disappointed, becoming known around Morningstar’s offices as “Dean Witter Value Subtracted.” I cannot track down its early returns, as the fund’s frequent mergers have befuddled Morningstar’s data sleuths, but I can approximate those totals. The following chart depicts the performance of the equally weighted S&P 500 (for which I do have returns) from January 1986 through May 1998, at which time the fund underwent its first transition.

The First Equally Weighted Fund

Growth of $10,000, cap-weighted vs. equal-weighted, Jan. 1986 - May 1998.

An inauspicious result. The equally weighted index, represented by the red line, did not lag its traditional competitor by much, but losing is still losing. Worse, because the fund carried a steep 1.80% expense ratio—in the fund industry, “value added” means “hold your wallets and clutch your purses”—its net return, shown by the orange line, was anemic. By mid 1998, investors who had purchased the fund on its launch date were 26% poorer than if they had bought Vanguard 500 Index VFINX.

That result scotched the future of equally weighted mutual funds. Invesco had launched an equally weighted S&P 500 fund in 1997 (Invesco Equally-Weighted S&P 500 VADDX), and an organization called ONEFUND did so a decade later (ONEFUND S&P 500 Equal Weight Index INDEX), but otherwise the field was abandoned. Exchange-traded funds, which will index pretty much anything, picked up some of the slack, but even so, only 19 equally weighted U.S. equity funds of any flavor currently exist, and none except for Invesco’s funds possess significant assets.

The Comeback

That’s too bad. Since summer 1998, the equally weighted strategy has soared. As the next chart shows, a costless version of the equally weighted S&P 500 portfolio has thrashed the conventional index.

Since Then...

Growth of $10,000, cap-weighted vs. equal-weighted, June 1998 - April 2023.

There are two possible reasons for the equally weighted portfolio’s improvement. One, the portfolio invests in smaller companies. To be sure, this distinction is decidedly relative, as its businesses are huge by most standards. Half the equally weighted portfolio is invested in firms with market caps exceeding $30 billion. But the comparable figure for the customary S&P 500 is $150 billion. By the standards of that index, Intel INTC, Boeing BA, and BlackRock BLK are little fish.

Thus, if smaller companies have outgained their larger rivals over the past 25 years, the equally weighted portfolio should have benefited. The same principle applies to the performance of value stocks versus growth companies. Because “glamor stocks” typically dominate the top positions of the conventional index, its portfolio tends to be more expensive, in aggregate, than the equally weighted index’s. The latter should therefore prosper when value stocks lead the way.

Testing the Hypothesis

We can evaluate those effects by comparing an artificially constructed investment consisting of 1) the equally weighted index minus the cap-weighted index against the returns of 3) small companies minus large companies, and 3) value stocks minus growth stocks. (The first calculation uses indexes from S&P, while the latter two use Morningstar indexes.)

What Caused the Outperformance?

Growth of $10,000, June 1998 - April 2023.

The picture tells the story. The red and gray lines behaved more similarly than did the red and green lines, indicating that the equally weighted portfolio performed more like a small-company investment than a value portfolio. That said, the equally weighted portfolio did indeed favor value, as shown by their joint second-half decline.

Four Investment Strategies

The chart suggests that the equally weighted portfolio punched well above its weight, because it finished above both of its influences rather than somewhere in the middle. Which leads to the following question: Would investors have been better off owning an equally weighted fund than placing half their assets into a small-company fund and half into a value-stock fund?

The answer is an unqualified “yes.” Over that same period, I compared the total returns for Invesco Equally-Weighted S&P 500 against a hypothetical portfolio that combined equal parts of Vanguard Small Cap Index NAESX and Vanguard Value Index VIVAX. Invesco’s fund easily exceeded that small/value blend—and each individual component, as well.

Total Returns

June 1998 - April 2023.

Conclusion

I cannot explain why the equally weighted portfolio has been superior to the sum of its parts. I cannot prophesy that its success will continue. Nor can I generalize about the strategy’s effectiveness when employed on indexes beside the S&P 500. I am merely reporting the findings, which have been impressive. Dean Witter’s fund suffered from poor timing, and even more greatly from absurdly high expenses. Its failure tarnished the reputation of equally weighted indexes. As the past 25 years have demonstrated, though, the concept clearly possesses merit.

This column’s final exhibit shows the 12 broad-based U.S. equity funds that use equally weighted indexes (Invesco also offers several equally weighted sector funds), along with their investment type, the index that they emulate, and their expense ratio. Historically, the ETF versions of these funds have not distributed capital gains. However, given the inherent tax inefficiency of equally weighted strategies, which must be constantly rebalanced, they may not suit all taxable accounts.

A table listing the 12 U.S. stocks that equally weight some portion of the entire market (as opposed to sectors). The table shows the name of each fund, its investment type, what index it equally weights, and its expense ratio.

The opinions expressed here are the author’s. Morningstar values diversity of thought and publishes a broad range of viewpoints.

The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.

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