The S&P 500 equal-weighted index has experienced a challenging period in recent years, lagging considerably behind its tech-heavy counterpart. Over the last five years, the equal-weighted index has appreciated by 63%, whereas the more frequently referenced cap-weighted index has seen a remarkable 93% increase. In the past 12 months alone, the equal-weighted index has managed only a 2% gain, while the cap-weighted version climbed by 12%.
This underperformance is largely attributed to the overwhelming dominance of technology and tech-adjacent stocks in the market. Since larger market-cap stocks significantly influence the cap-weighted index, they have driven most of its gains. Conversely, the equal-weighted index treats all components equally, which has led to its recent lackluster results.
However, recent market shifts might hint at a potential turning point for the equal-weighted index. A recent sell-off in the tech sector, particularly among mega-cap stocks, has raised concerns among investors regarding inflated valuations. For instance, the Technology Select Sector SPDR Fund (XLK) has fallen 5.6% since November 3. During the same timeframe, the cap-weighted S&P 500 index has declined by 2.7%, in stark contrast to the equal-weighted index’s minimal drop of just 0.4%.
As this trend persists, the equal-weighted index presents a viable means of hedging against the concentrated risk associated with the cap-weighted strategy. Hank Smith, director and head of investment strategy at The Haverford Trust Company, emphasized that concentrated holdings in a few volatile stocks can lead to significant downturns, a reality that may not be fully recognized by many investors.
Currently, a mere ten stocks in the S&P 500 account for over 40% of the index’s weight, with heavyweights like Nvidia, Microsoft, and Apple comprising about 25%. Smith underscored the implications of such concentration, suggesting that the risks associated with investing in the S&P 500 are heightened.
Despite its recent struggles, there are indicators that the equal-weighted index could outperform its cap-weighted counterpart in the future. Historically, from 1989 to 2023, the equal-weighted index has outpaced the cap-weighted version by an average of 1.05% annually, according to Invesco. Additionally, the equal-weighted index currently boasts lower valuations, with a 12-month forward price-to-earnings (P/E) ratio around 22, compared to approximately 30 for the cap-weighted index. This discrepancy in valuations has reached historically significant levels.
Furthermore, expectations for broader economic growth, particularly fueled by AI-related investments, could provide a lift to the equal-weighted index. Smith pointed out that advancing economic conditions may lead to more widespread benefits across the market, suggesting that the equal-weighted S&P 500 could see improved relative performance over the next six to nine months.
As investors navigate the complexities of the current market landscape, the equal-weighted index stands out as a potential alternative, particularly for those wary of excessive concentration in heavy-hitting tech stocks.
