To weight or not to weight— That is the question
Authors & Contributors
Contributing authors: Roy Willis Jr., CFA, Portfolio Manager and Vincent Tumminello, CFA, Senior Portfolio Analyst
There are multiple ways to construct indexes. Given recent gains in the largest cap stocks held in the S&P 500®, some investors are considering moving from the “standard” market-cap weighted investment models to equal weighted.
Their goal is to level potential risk brought by dependencies on performance of the largest stocks. But equal weighting brings its own set of challenges.
S&P 500 Market Weight vs. S&P 500 Equal Weight
The year-to-date performance of large cap growth stocks, particularly the Magnificent Seven, has increased scrutiny on benchmark concentration risks. In response, equal-weighted benchmarks have attracted attention as an alternative. While an equal-weighted benchmark may solve one issue, it may inadvertently introduce an implicitly active approach to an otherwise passive allocation.
Avoiding the concentration risks of the Magnificent Seven in market cap weighted benchmarks may seem enticing to some investors, but moving toward equal-weighted benchmarks may cost more in trading fees, along with other issues that often accompany higher benchmark turnover rates. Securities added to the S&P® 500 tend to be smaller, growth-oriented momentum stocks. As a result, for equal-weighted versions of the benchmark the indexing mechanism may overweight these new securities, as well as underperforming companies that remain in the index, when compared to the market-cap weighted peer.
Turnover is another factor to consider with the upcoming S&P 500 rebalance on December 20. With only two changes, turnover for the S&P 500 is at approximately 0.4%, at the lower end of recent rebalances. However, turnover for the equal-weighted version of the S&P 500 is significantly higher. Increased turnover often results in higher trading fees and commissions and may create capital gains subject to higher income tax rates. Investors must consider how the potential cost of equally distributing their holdings affects their ability to achieve their goals.
So, to weight or not to weight? The answer depends on whether avoiding a heavy large cap concentration is worth the series of small tradeoffs of achieving a greater balance.
PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.
All investments involve risk, including the possible loss of principal. Certain investments have specific or unique risks. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment.
This material has been provided for informational purposes only and should not be construed as investment advice or a recommendation of any particular investment product, strategy, investment manager or account arrangement, and should not serve as a primary basis for investment decisions. Prospective investors should consult a legal, tax or financial professional in order to determine whether any investment product, strategy or service is appropriate for their particular circumstances. This document may not be used for the purpose of an offer or solicitation in any jurisdiction or in any circumstances in which such offer or solicitation is unlawful or not authorized. Views expressed are those of the author stated and do not reflect views of other managers or the firm overall. Views are current as of the date of this publication and subject to change. This information may contain projections or other forward-looking statements regarding future events, targets or expectations, and is only current as of the date indicated. There is no assurance that such events or expectations will be achieved, and actual results may be significantly different from that shown here. The information is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be, interpreted as recommendations. Charts are provided for illustrative purposes and are not indicative of the past or future performance of any BNY product. Some information contained herein has been obtained from third party sources that are believed to be reliable, but the information has not been independently verified. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.
Indices referred to herein are used for comparative and informational purposes only and have been selected because they are generally considered to be representative of certain markets. Comparisons to indices as benchmarks have limitations because indices have volatility and other material characteristics that may differ from the portfolio, investment or hedge to which they are compared. The providers of the indices referred to herein are not affiliated with Mellon Investments Corporation (MIC), do not endorse, sponsor, sell or promote the investment strategies or products mentioned herein and they make no representation regarding the advisability of investing in the products and strategies described herein. Investors cannot invest directly in an index.