Equal Weight, Unequal Benefits: Why We Prefer Market-Cap-Weighted Indices

Quick Take

The stock market has performed well this year, driven largely by a few major companies, especially in the tech sector.
While there has been greater interest in equal-weighted indices as market-cap weighted indices become more concentrated. Still, market-cap-weighted indices are more reflective of the overall market and offer advantages like lower turnover and greater tax efficiency.
Diversification is key, but there are better ways to manage risk than focusing on equal-weighted funds.

Despite a bumpy August and start to September, the stock market has been on a winning streak this year. The global stock market surged 16% in the first seven months and has climbed 23.4% over the past 12 months.

These gains, however, have been driven by a few standout performers, particularly in the race to harness the power of artificial intelligence. This year, the biggest players in the S&P 500 have significantly outperformed the average stock, creating a noticeable performance gap between market-cap weighted and equal-weighted indices. This heavy concentration of success in large companies has sparked growing interest in equal-weighted stock indices and funds to ensure diversification. But does this mean equal-weighted funds are superior? Not necessarily.

The Difference Between Market-Cap and Equal-Weighted Indices

Market-cap weighted stock indices are designed to reflect the size and influence of companies within the market. Larger companies receive a higher weighting in these indices, making them more representative of the broader market's movements.

In contrast, equal-weighted indices treat all companies equally, regardless of size or sector. While this approach may offer greater diversity across the board, it often underrepresents the performance of large, leading companies.

Why Market-Cap Weighting Matters

There is an inherent connection between a company’s size in the market and its value to shareholders. Market-cap weighted indices factor in this relationship, incorporating market forces into their portfolio construction. Larger companies are often seen as more valuable by investors, driven by their sizable revenue, profits, and potential future cash flows.

Equal-weighted indices, on the other hand, disregard these market signals and spread investments evenly across all companies, regardless of their actual value or growth prospects. While this might seem like a more balanced approach, it overlooks important indicators that guide investment decisions.

In a market-cap weighted index, the most successful companies often rise to the top. Investors reward growth and profitability, driving up share prices of high-performing companies. This introduces a momentum effect that can push market-cap weighted indices higher. However, this can also result in increased concentration in a few large companies—something we've seen recently with the S&P 500. While this might raise concerns about a market dominated by a handful of giants, it’s an inherent feature of market-cap weighting.

Efficiency and Turnover: A Hidden Advantage

One often overlooked advantage of market-cap weighted indices is their lower turnover, which translates to greater tax efficiency. Equal-weighted indices require frequent rebalancing to maintain equal weightings, which leads to higher transaction costs and potential capital gains taxes.

For example, according to Morningstar, one popular exchange-traded fund (ETF) that tracks the market-cap weighted S&P 500 only buys or sells about 2% of its assets each year. In contrast, an equal-weighted S&P 500 ETF turns over approximately 21% of its assets annually, potentially passing on a larger tax bill to fund holders.

What's Next for Large Companies?

Will the biggest companies continue to lead the stock market? If you’re concerned about the influence of a few large companies on overall market performance, there are smarter ways to manage your portfolio than simply focusing on equal-weighted funds.

Over the past few years, the market-cap weighted S&P 500 has consistently outperformed its equal-weighted counterpart, largely due to the strong performance of tech giants like NVIDIA, Meta, and Google. As we’ve discussed previously (Mid-Year Momentum), it’s not unusual for a handful of stocks to drive the majority of market gains.

Diversification Still Matters

While maintaining a diverse portfolio is crucial, there are better ways to diversify than relying on equal-weighted funds. Consider exploring investments outside of the S&P 500, such as small and mid-sized stocks or international markets. These options can help balance the risks of a top-heavy U.S. stock market while providing broader exposure to growth opportunities.

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DISCLOSURES: The information provided in this letter is for general informational purposes only and should not be considered an individualized recommendation of any particular security, strategy, or investment product, and should not be construed as investment, legal, or tax advice. Proffitt & Goodson, Inc. makes no warranties with regard to the information or results obtained by third parties and its use and disclaims any liability arising out of, or reliance on the information. The information is subject to change and, although based on information that Proffitt & Goodson, Inc. considers reliable, it is not guaranteed as to accuracy or completeness. Source information is obtained from independent financial data suppliers (Interactive Data Corporation, Morningstar, etc.). The Market Categories illustrated in this Financial Market Summary are indexes of specific equity, fixed income, or other categories. An index reflects the underlying securities in a particular selection of securities picked due to a particular type of investment. These indexes account for the reinvestment of dividends and other income but do not account for any transaction, custody, tax, or management fees encountered in real life. To that extent, these index numbers are artificial and cannot be duplicated in real life due to the necessity of paying those transaction, custody, tax, and management fees. Industry and specific sector returns (technology, utilities, etc.) do not account for the reinvestment of dividends or other income. Future events will cause these historical rates of return to be different in the future with the potential for loss as well as profit. Specific indexes may change their definition of particular security types included over time. These indexes reflect investments for a limited period of time and do not reflect performance in different economic or market cycles and are not intended to reflect the actual outcomes of any client of Proffitt & Goodson, Inc. Past performance does not guarantee future results.

Equal Weight, Unequal Benefits