Last year witnessed a remarkable 26% gain in the SPDR S&P 500 exchange-traded fund, largely attributed to the exceptional performance of the Magnificent Seven. These tech-stock giants, including Apple, Amazon.com, Alphabet, Meta Platforms, Microsoft, Nvidia, and Tesla, constitute over a quarter of the S&P 500's market value. However, many investors are concerned about the significant concentration risk posed by these dominant players and are exploring alternative investment strategies.
Equal-weight index funds offer a democratic approach to the market by assigning equal weight to each stock component. By reshuffling the S&P 500 in this manner, each company is relegated to a 0.2% slice of the index. Consequently, the focus shifts towards value-oriented and mid-to-smaller-cap stocks, providing diversification away from large-cap growth.
According to Nick Kalivas, head of factor and core equity product strategy at Invesco, the market-cap-weighted S&P 500 currently mirrors 45% of the Nasdaq 100, twice as much as it did a decade ago. Moreover, last year's rally increased the top 10 holdings' weight to 32% of the index, up from 25% at the beginning of 2023. In response to this trend, Invesco manages the $49.6 billion Invesco S&P 500 Equal Weight ETF, the largest fund of its kind in terms of assets.
Given the top-heavy nature of the market-cap-weighted S&P 500 and its focus on growth, many investors are turning to equal-weight index funds as a viable alternative. These funds provide exposure to all 500 stocks while mitigating the risks associated with concentration. According to Nick Kalivas, there has been an average annual inflow of $5.3 billion into equal-weight S&P 500 ETFs over the past five years, with an additional $616 million in inflows recorded so far this year.
Matt Dmytryszyn, chief investment officer at financial advisory Telemus, is actively considering the Invesco fund for client portfolios. He is particularly drawn to its lower valuation compared to the standard S&P 500. Currently, the standard S&P 500 is trading at 19.6 times 2024 earnings, whereas the equal-weight index boasts a more attractive valuation at 16.1 times earnings.
In conclusion, equal-weight index funds offer investors an opportunity to diversify their portfolios and reduce concentration risk. With the market increasingly dominated by a handful of tech giants, these alternative strategies allow investors to gain exposure to a broader range of stocks while potentially benefiting from more favorable valuations.
New Investment Strategy: Equal-Weight Index ETFs for Diversification
As the potential for Federal Reserve rate cuts looms, CEO of Astoria Portfolio Advisors, John Davi, is taking steps to adapt client portfolios to a new market cycle. His strategy involves incorporating several equal-weight index ETFs, such as the Invesco S&P 500 Equal Weight Technology ETF and the Invesco S&P 500 Equal Weight Energy ETF, into these portfolios.
Davi believes that if the Fed proceeds with rate cuts, it will initiate a new cycle. He poses the question, "If there's no more earnings recession, why not diversify to the mid-cap range of these sectors?"
According to Kalivas, equal-weight strategies tend to deliver strong performance during periods of accelerating profit growth, as they exhibit a small- and mid-cap tilt.
Early market action in 2024 indicates a larger pool of winners in the large-cap segment. Chief Investment Officer at Cornerstone Financial Services, Daniel Milan, suggests that investors seeking broader technology exposure should consider an ETF like the First Trust Nasdaq-100 Equal Weighted Index, with assets totaling $2.3 billion.
It's worth noting that equal weighting can be applied to any sector or country index, but its benefits are most evident in large-cap indexes. Davi and Milan recommend replacing approximately one-third of large-cap weighted ETFs with equal-weight ETFs to diversify core holdings.
However, keep in mind that these strategies are long-term in nature, as short-term returns may vary significantly. For instance, while the SPDR S&P 500 ETF gained 26% last year, the Invesco S&P 500 Equal Weight only rose by 13.7%, as reported by Morningstar. Nevertheless, over time, equal weight tends to outperform. Research conducted by S&P Dow Jones reveals that the S&P 500 Equal Weight Index yielded a return of 11.5% over the 20-year period leading up to 2023, compared to the market-cap weighted S&P 500's 10.3% return.
In Milan's words, "If you're going to do equally weighted indexes, you have to commit to it."
