Is the Equal-Weighted S&P 500 Index Poised for Growth?
In recent years, the S&P 500 equal-weighted index has struggled to keep pace with its cap-weighted counterpart. Over the past five years, it has gained 63%, trailing the tech-heavy cap-weighted index’s impressive 93% increase. In the last year alone, the equal-weighted index rose a modest 2%, compared to the 12% climb of the cap-weighted index.
The reason for this disparity is straightforward: dominance by tech and tech-adjacent stocks. These stocks, with their large market capitalizations, heavily influence the cap-weighted index’s performance. Conversely, the equal-weighted index assigns equal importance to all its constituents, regardless of size.
However, the recent sell-off in the tech sector and mega-cap stocks may signal a turning point for the equal-weighted index. As investors reassess the high valuations of tech stocks and spending on AI, the Technology Select Sector SPDR Fund (XLK) has declined by 5.6% since November 3. This has pulled the S&P 500 cap-weighted index down by 2.7% within the same timeframe, while the equal-weighted index has only dipped by 0.4%.
If the shift away from tech stocks continues, the equal-weighted index might offer a hedge against the concentrated risks of the cap-weighted strategy, which relies heavily on a few key stocks. “At any point in time you could have a very big drawdown in these stocks, and that would not be unusual because these are volatile stocks,” commented Hank Smith, director & head of investment strategy at The Haverford Trust Company, referring to AI-focused mega-cap stocks.
Smith also highlighted the significant concentration within the S&P 500 index: “I don’t think a lot of investors understand the risk they’re taking buying the S&P 500 index when you consider 10 names in a 500 stock index represent 40% plus of the index,” he noted. “Three names represent 25 give or take% of the S&P 500: Nvidia, Microsoft and Apple. That is extraordinary concentration.”
Despite its recent underperformance, the equal-weighted index has historically outperformed the cap-weighted index by an average annual margin of 1.05% from 1989 to 2023, according to Invesco. Additionally, the equal-weighted index offers lower valuations, with a 12-month forward PE ratio of around 22, compared to 30 for the cap-weighted index.
Smith suggests that expanding economic growth, driven by AI investments, could further benefit the equal-weighted index. “If we’re correct on our economic outlook, stronger growth would support that broadening out,” he said. “And that would suggest that maybe over the next 6 to 9 months, you might see better relative performance from the equal-weighted S&P 500.”
