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Market Weight vs. Cap Weight
08/04/2016 9:00 am EST
Can you beat the S&P 500 by using the S&P 500? It may be possible over time with an equal weight S&P 500 strategy, notes Stephen McKee, editor of Selections & Timing.
The more familiar strategy is known as Capital weighting (or cap weighting) and is used by the well-known SPDR S&P 500 ETF (SPY).
This uses a company's market price and the number of outstanding shares to determine the percentage weighting of the company's inclusion in the index.
The larger the components, the larger that company will be weighted (allocated assets) in the portfolio.
Equal weighting, however, distributes the same investment amount into each company stock in the same pro-rata amount. All companies, regardless of their capital size, will thus be represented equally in the index.
There are of course pros and cons to each strategy. Which is best? Before answering, let's look at a simple example to show more clearly the difference between cap weighting and equal weighting.
For example, the four companies below are included in the same portfolio, but each company is weighted differently based upon the components.
To determine the percentage of each stock's weight, we take each companies market price and multiply it by the number of shares outstanding, and then we take this amount and divide it by the total market-cap for the portfolio.
Although "Company 2" and "Company 3" have the same amount of # of shares outstanding, "Company 2" is has a larger weight because it has a higher market price per share.
- Reduced investor risks because more money goes to the larger more stable companies
- Can be used as a measurement of the stock market in relation to the economy
- Investor opportunity loss if small cap area grows more quickly
- Risking of low diversification to the index being heavily influenced by few large cap companies
- Over weighted on a few mega companies
As mentioned, equal weighting distributes the weight evenly throughout the index fund regardless of market capitalization or size relative to the economy. Using the above example, this portfolio would allocate the same dollar amount into each position.
- High equally diversified equity exposure
- More exposure to the small- and mid-caps which may have a higher growth potential
- Smaller companies have a higher risk of failure
- No clear distinction of stock size in relation to the economy
- Rebalancing may lead to higher stock turn-over rates
So which approach is better, if there is one? Can we outperform the S&P 500 using the S&P 500, but changing the selection approach? The chart below shows this has been happening.
This graph compared the longest history between the two weighting approaches, but to avoid the front-end load and higher internal expenses, I have also compared VFINX to RSP, which is the Guggenheim S&P 500 Equal Weighted ETF.
In this example over about 13 years, VFINX ended $300, while RSP ended at $385. Again, over time, the equal weighted index outperformed the cap weighted index.
Understand the pros and cons of each approach before making changes. For example, typically in bear markets, the cap weighted index may outperform (even though both may be declining) the equal weighted index. This may be because of the lower small company weighting.
In bull markets, the equal weighted index may outperform the cap weighted index. This again may be because of the smaller company equal weighting.
By Stephen McKee, Editor of Selections & Timing
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