Bob’s Journal
Investors in index funds might want to consider moving to funds that equally weight each stock.
The major stock indexes are capitalization-weighted, or cap-weighted. That means each stock’s weight in the index is determined by its market capitalization, which is the value of its outstanding shares of stock.
The greater the fund’s capitalization, the larger its percentage of the index. Cap-weighting also means that as a stock’s price rises faster than the overall market, the stock’s share of the index increases.
Investing in a cap-weighted index is a form of momentum investing. More and more of your investment is in the stocks that have done well recently.
If you bought an S&P 500 Index fund today (you’d actually own a little over 500 stocks), almost 22% of your investment will be in the 10 largest positions. Apple (APPL) would be 4.24% of the fund. Microsoft (MSFT) would be 3.43% and Amazon (AMZN) would be 3.07%.
The significance of each stock declines quickly after that. Each stock after the 14th largest positions is less than 1% of the index.
Cap-weighting also focuses the portfolio in the top-performing sector. Technology is more than 23% of the SPDR S&P 500 ETF (SPY). Financial services is more than 16% and health care is more than 14%.
One analysis concluded that half of the year’s gains in the S&P 500 were accounted for by the tech sector, and 30% of the gains were due to four stocks: Apple, Amazon, Alphabet/Google and Microsoft.
Cap-weighting works great when the recent momentum continues. But it can leave your portfolio concentrated in a few stocks that have done well the last few years and now have very high valuations. If there’s a bubble in the market, it’s in your portfolio. When market trends change, the index fund will be buffeted.
That’s why it can be a good idea to consider an equal-weighted fund instead of a cap-weighted fund. You’re still not depending on a manager to select the best stocks in the market. The equal-weighted fund has the same stocks as the index and the cap-weighted fund. But, as the name says, the fund gives each stock an equal weight in the portfolio and rebalances from time to time as the market changes the weighting.
Equal weighting gives you more exposure to small and mid-cap companies, which is where most of the growth traditionally is. It also makes you less dependent on growth stocks than a cap-weighted index. An equal-weighted index fund further has the low costs and tax advantages of other index funds.
Over the long-term, equal-weighted indexes outperform cap-weighted indexes with less volatility. But cap-weighted indexes do better during the strong market rallies.
For example, the Invesco S&P 500 Equal Weight ETF (RSP) returned 10.79% annualized over 15 years, 11.26% over 10 years, 11.76% over five years, 11.41% over three years and 14.35% for 12 months. For the same periods, the SPDR S&P 500 ETF (SPY) returned 9.61%, 10.51%, 13.11%, 13.20%, and 17.18%. The equal-weighted fund has higher returns over the longer periods but lower returns over the recent periods.
The Invesco Russell 1000 Equal Weight ETF (EQAL) has been around a little over three years. Its three-year annualized return is 11.05% and its 12-month return is 15.60%. The comparative numbers for the iShares Russell 1000 (IWB) are 12.89% and 17.25%. So, equal weight lags a bit during the recent periods.
The advantages of equal-weighting are less evident if you’re already invested in a small-cap or mid-cap index. But if you’re in one of the large-cap indexes such as the S&P 500 or Russell 1000, consider equal-weighting as a way to reduce your risk from an extended market and increase long-term returns. Of course, if you expect recent market trends to continue, you should stay in a cap-weighted index fund and enjoy the ride as long as it lasts.
The Data
The non-manufacturing economy might have slowed a bit. The ISM Non-Manufacturing Index declined to 55.7 from 59.1. That’s still solid growth, but it was well below recent numbers and expectations for the month.
The PMI Services Index also declined, but less so. It came in at 56.0, down from 56.5. This also was below expectations.
Consumers slowed their pace of borrowing last month. Revolving credit surged the previous month but declined a small amount in the latest month. Auto and student loans increased modestly.
Inflation’s taking a breather, according to the Producer Price Index. It was unchanged in the latest month, but it is up 3.3% over 12 months. Excluding food and energy, the index rose 0.1% for the month and is up 2.7% over 12 months.
Last Friday’s Employment Situation reports were a little below expectations, but they still showed a very strong labor market for very late in the economic cycle. Jobs created were only 157,000, but last month’s number was revised higher to 248,000 from 213,000.
Despite the strong labor market, hourly earnings increased by only 2.7% over 12 months and 0.3% for the latest month. That’s much higher than for most of this recovery but well below what’s normal for such a low unemployment rate.
The JOLTS (Job Openings and Labor Turnover Survey) is more detailed than the Employment Situation reports but lags them by a month. The latest JOLTS showed another sharp increase in job openings, and last month’s openings were revised higher. The number of job openings increased 8.8% over the last 12 months. Layoffs remain very low, while the quits rate remains near the long-term average.
Job openings continue to exceed hires by one million as employers say they have trouble finding qualified workers.
New unemployment claims declined another 9,000. As usual, all the claim numbers are near historic lows.
The Markets
The S&P 500 gained 1.64% for the week ended with Wednesday’s close. The Dow Jones Industrial Average rose 0.99%. The Russell 2000 returned 1.09%. The All-Country World Index increased 0.78%. Emerging market equities declined 0.45%.
Long-term treasuries gained 0.28% for the week. Investment-grade bonds rose 0.06%. Treasury Inflation-Protected Securities (TIPS) returned 0.14%. High-yield bonds increased 0.31%.
On the currency front, the dollar rose 0.56%.
Energy-based commodities declined 0.12% for the week. Broader-based commodities returned 1.33%, while gold lost 0.26%.
Bob’s News & Updates
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