Poor performance among mega-cap stocks has dragged down the Standard & Poor’s 500 lately, along with the index funds that track it. But one version of the S&P 500 hasn’t come under quite as much pressure, and big investors are starting to take notice.
The benchmark S&P 500 index, a market-weighted basket of 500 widely held stocks, often is hailed as the best snapshot of the overall market. But because its constituents are weighted by market cap, the 175 largest issues control about 80 percent of the index’s movement. That can mean tough times when mega-caps are down, a point that’s been underscored recently by an investigation of the insurance industry and problems facing large drug companies.
This mega-cap bias is eliminated in the S&P Equal Weighted index, which follows the same list of stocks in another way — often with dramatically different performances, depending on market conditions. Unlike the market-weighted version, the equal-weighted S&P index allocates a fixed 0.2 percent weighting to each of the 500 securities.
Advocates say the equal-weighted structure offers greater diversity and limits over-concentration by sector or market cap. Detractors are unconvinced, arguing that the whole point of indexing is to own the market, and if you discard market weightings, you lose that benefit.
Research conducted by S&P found that the equal-weighted index does offer some distinct advantages, however. In addition to higher exposure to the smaller large-caps, it delivers greater value exposure, which some investors may find appealing. But what’s really piqued the interest of institutional investors is the Equal Weighted index’s performance history. It consistently has beaten the traditional benchmark, returning 12.65 percent during the past 10 years, compared with 11.09 percent for the S&P. Over the past five years, it has gained 7.08 percent, compared with a 1.31 percent decline for the traditional index. And for the 12 months ending Sept. 30, the equal-weighted index was up 19.76 percent, compared with just 13.87 percent for the S&P.
“When people look at the numbers and compare, that’s the first thing that strikes them, and that’s what’s created the interest we’ve seen,” said Srikant Dash, index strategist with Standard & Poor’s.
While assets linked to the equal-weighted index are nowhere near the $1.1 trillion pegged to the traditional S&P 500 index, interest is on the rise. There’s currently $3.5 billion invested in funds tracking the equal-weighted index, up from $2.4 billion at the end of 2003. A good portion of that has come from state pension funds. According to public filings, the New York State Teachers’ Retirement System invested $1 billion during the summer, and Vermont’s three statewide, public retirement plans recently allocated $450 million.
There are some downsides to the equal-weighted index. Its fixed allocation structure requires more frequent re-balancing — quarterly, rather than annually — which leads to higher turnover and increased trading costs. The resulting fees may not sit well with cost-conscious index investors, and also may bring some tax implications. Also, during periods when mega-cap stocks lead the market, the equal-weighted index may underperform the market.
The main argument against equal-weighting is more philosophical. Index investors want their portfolios to accurately reflect the market, and the market determines the value of each company, factoring in many pieces of information to assign a share price. That means if General Electric Co. is the biggest company in the S&P 500, it gets a more substantial allocation than lesser stocks — 3.2 percent, in fact, as opposed to the .08 cent that the stock with the lowest market share might get.
Equal-weighted indexing is not a new idea — Wall Street has been experimenting with it for more than three decades, and the vast majority of active managers build their portfolios on an equal-weighted basis. In the early days of indexing, however, higher trading costs associated with frequent re-balancing made equal-weighted indexes unattractive to large investment houses. Lower commissions and modern trading tools make them less onerous to manage today.
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