Market Cap Weighting vs. Equal Weighting: It Might Be Time To Shift Your Strategy

Mega-caps have dominated the markets for a few years now, but that's likely to change soon.

Throughout 2023 (and really throughout much of the past decade), large-caps have been an overwhelming investor favorite. Earlier this year, when the path of inflation was still very unclear and the fear of impending recession was being offset by remarkably resilient GDP growth and a tight labor market, investors found the S&P 500 and the mega-cap tech names, in particular, to be the sweet spot for their portfolios. They provided just the right combination of risk exposure without overdoing it and the markets responded.

That culminated, of course, with the AI rally that resulted in the “magnificent 7” stocks producing almost all of the market’s gains. That wasn’t the peak of mega-cap outperformance though. It was merely the catalyst. Mega-caps and the Nasdaq outperformed the broader market pretty much from day 1 this year and they haven’t relented since.

That trend isn’t going to last forever though. In fact, it’s easy to make the argument that large-caps have outperformed far longer than they should have. As it stands today, smaller company stocks are at their lowest level relative to the S&P 500 since the COVID bear market bottom. If they clear that, you’d have to go back to 2009 to find the next low.

You might be wondering why I’m using the S&P 500 equal weight index instead of the Russell 2000 as my smaller company benchmark. For one, pure small-caps tend to have their own set of market dynamics that make them much different than large-caps. They’re much more debt-reliant. They’re typically much more growth-oriented. They’re more vulnerable to economic cycles. Using the equal weight S&P 500 keeps the comparison within the large-cap universe, where business structures, balance sheets and life cycles tend to be more comparable, and gives a better sense of where the relative value lies.

Why The S&P 500 Has Outperformed

Looking at the 20-year chart of the equal weight S&P 500 vs. the traditional market cap weighted S&P 500, you can see some pretty clear narratives driving large-cap outperformance (represented by declines in this ratio).

• The financial crisis was one of the biggest risk-off events in market history. With so many areas of the economy vulnerable at this point, especially in banks and financials, it makes sense that investors preferred the safety and durability of big companies.

• 2011-2012 was the peak of the Greek debt crisis, but there were concerns that this was merely an indication that there were government debt problems potentially all over the world. Again, investors moved into safer havens and the large-caps led the way.

• 2015 was the junk bond crisis. Same story again.

• 2016-2019 is the period where the Fed finally tried to normalize monetary policy for the first time since the financial crisis. It also marked one of the longest periods of relative market calm in history. In 2017, the VIX only touched so much as the 16 level twice FOR THE ENTIRE YEAR! It spent the last 8 months of the year averaging around 10. There was simply no reason for investors to test the waters with small-caps when they were getting 20% returns with plain beta investments.

In the 2020s, we’ve had the highest inflation regime since the 1970s that has thrown pretty much everything we think we know about market relationships and expectations right out the window, but now that inflation has at least come back down to a more manageable level and it looks as if the Fed has finally reached the end of its hiking cycle, a more normal market environment may finally be returning.

That means traditional market fundamentals and where we are in the economic cycle should start mattering again.

If you want to look purely at valuations, the equal weight S&P 500 clearly offers better value. The S&P 500 trades at 19 forward earnings, but the equal weight index is currently at less than 15. That’s only one factor to consider though. If we break the two indices down into their respective risk factors, we get a clearer picture of what’s going to impact each one in the future.

The Fama-French five factor model breaks historical performance and risk exposure down into five factors - market risk (Rm-Rf), small company (SMB), value (HML), profitability (CMA) and conservative investment (CMA). The higher the number, the greater its exposure to the factor.

The results probably aren’t surprising given how large-cap growth, especially at the top, now dominates the index. Broad market risk explains most of the indices’ historical returns, but there are some tilts. The equal weight index is, not surprisingly, more exposed to small company risk. It’s also tilted towards value and, maybe surprisingly, conservative investing. If any one of these factors begins outperforming the market, there’s a better chance that the equal weight version of the index will do better.

Given that, it’s understandable why we’ve seen the traditional S&P 500 do so relatively well in recent years - they’ve been dominated by the FANG stocks. Small-caps and value stocks have had their moments, but they’ve been few and far between. 2022 was probably the best run for these groups, but it was almost entirely due to the tech stock correction and that underperformance was quickly recaptured earlier this year.

That also helps skew risk-adjusted performance in favor of the cap weighted index.

Over the past 20 years, the returns of the cap weighted and equal weight S&P 500 have been virtually identical, but the equal weight index has taken 15% more risk to achieve the same return, not exactly what you want to see. Its deepest drawdown has been greater and risk-adjusted performance has been weaker.

Why The Equal Weight S&P 500 Could Be Ready To Outperform

Outside of relative value and the fact that the small cap factor has failed to deliver outperformance over large-caps for 14 years, the real case for smaller companies/equal weight S&P 500 taking the lead is where we are in the current economic cycle.

As we approach recessionary environments, which it certainly seems like we are right now, more conservative investments tend to outperform. Investors want to position themselves more defensively heading into a downturn and we traditionally see investments, such as low volatility, bonds and large-caps, performing better.

It’s when expectations for the economy had finally bottom out and begin to turn that small-caps and value stocks usually take off. Unfortunately, it’s impossible to tell when that point arrives until after it’s happened, but there’s usually enough of a follow through that outperformance can be had for several quarters after the turn. I think we’re still in the first part of the cycle now where defense has yet to make its extended run, but I wouldn’t be surprised to see things pivot by summer 2024. It’s just my 30,000 foot guess. I don’t have a crystal ball!

Since the equal weight S&P 500 is more tilted towards small-caps and value stocks, I think it’s very well-positioned to lead the traditional S&P 500 for a while (once we finally clear this current cycle).

Another way to play the turn could be to overweight small-caps, but it feels like there’s still too much danger in the near-term. Pivoting core positions from cap weighted to equal weight strategies creates just a minor shift in the overall risk/return profile, but also puts portfolios in position to outperform over the next 2-3 years.

It seems like investors may already be considering this move looking at ETF flows for 2023.

Not surprisingly, the Vanguard S&P 500 (VOO), the iShares Core S&P 500 ETF (IVV) and the Vanguard Total Stock Market ETF (VTI) have three of the four biggest net inflows of the year (the SPDR S&P 500 ETF (SPY) is often used more as an institutional trading vehicle and flows can swing wildly, so don’t read into the fact that it’s not on the list).

Look down the list and there’s the Invesco S&P 500 Equal Weight ETF (RSP) at #11 with net inflows of more than $7 billion. With $37 billion in assets, RSP is one of the 40 largest ETFs in existence, a fact that might be surprising given it mostly gets overshadowed by VOO, IVV, SPY and VTI, but it’s become a major player in the ETF space.

Conclusion

Shifting from VOO, IVV, SPY and VTI over to an equal-weight strategy, such as RSP, makes a lot of sense here. The next 6-12 months could see either cap weight or equal weight outperform, but I think if you’re willing to ride out some of the short-term volatility, RSP could be a long-term winner.