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“If you make a deal with a fool, don’t be surprised when they act foolishly.” -Jeffrey Archer
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Today’s blog is being written in response to a reader’s question about which is better: Cap Weighted funds or Equal Weighted funds. Before we can decide which is the better deal, Cap Weighted funds, or Equal Weighted funds, we’ll need some basic definitions.
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What is Cap Weighted?
According to Investopedia:
A Capitalization-Weighted Index, also known as a market value-weighted index, is a type of stock market index in which individual components of the index are included in amounts that correspond to their total market capitalization (shortened as “market cap”).
With the capitalization-weighted method, the index components with a higher market cap will receive a higher weighting in the index. Proportionally, the performance of companies with a small market cap will have less of an impact on the performance of the overall index. Other methods for computing the value of stock market indexes are the price weighted, fundamental weighted, and equal weighted index construction methods. What is Market Capitalization? A company’s market capitalization is calculated by multiplying its outstanding shares by the current price of a single share. In this way, market capitalization reflects the total market value of a firm’s outstanding shares.
Key Takeaways:
- A capitalization-weighted index is an index construction methodology where individual components are weighted according to their relative total market capitalization.
- The components with higher market caps carry greater percentage weights in the index. Conversely, the components with smaller market caps have lower weightings in the index.
- Critics of cap-weighted indices argue that the overweighting toward larger companies gives a distorted view of the market.
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What is Equal Weight?
Equal weight is a type of proportional measuring method that gives the same importance to each stock in a portfolio, index, or index fund. So stocks of the smallest companies are given equal statistical significance, or weight, to the largest companies when it comes to evaluating the overall group’s performance.
An equal-weight index is also known as an unweighted index.
Key Takeaways:
- Equal weight is a proportional measure that gives the same importance to each stock in a portfolio or index fund, regardless of a company’s size.
- Equal weight contrasts with weighting by market capitalization, which is more commonly used by indexes and funds.
- The concept of equally weighted portfolios has gained interest due to the historical performance of small-cap stocks and the emergence of several exchange-traded funds (ETFs).
- Equal-weighted index funds tend to have higher stock turnover than market cap-weighted index funds, and as a result, they usually have higher trading costs.
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Performance of Equal-Weighted vs Cap Weighted Indices
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According to Investopedia:
Small Cap stocks are generally considered to be higher risk, higher potential return investments compared to large-caps. In theory, giving greater weight to the smaller names of the S&P 500 in an equal-weight portfolio should increase the return potential of the portfolio. Historically, this has been the case—in the short term. From September 2020 to September 2021, the total one-year return for the S&P 500 Equal Weight Index (EWI) was 41.93%, vs. 33.72% for the traditional S&P 500 Index.
However, over the long term, the gap narrows. Research from S&P Dow Jones shows the S&P 500 Equal Weight Index had an 11.5% return over the 20 years through 2023. The market-cap weighted S&P 500 returned 10.3% over that period.
The cap-weighted index approach is the more traditional approach and the one that is most familiar to investors. Almost all S&P 500 funds are cap-weighted, meaning that larger stocks make up a bigger proportion of the Index and have a greater weight in performance than smaller stocks.
(For example, a cap-weighted S&P 500 fund owns about 200 times as much Microsoft MSFT (total market cap = $2.8 trillion) as it does U-Haul UHAL (total market cap = $13.8 billion).
If you own an equal-weighted fund, you own just as much stock in U-Haul as you do in Microsoft — and in every other stock in the S&P 500.) (Source: PaulMerriman.com)
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But Which One is Better?
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- Diversification– one of the main reasons most people invest in the S&P 500 is diversification. With cap-weighted indices, larger stocks, have a greater influence on the performance of the overall index and act as a diluting factor to diversification. The smaller, weighted stocks tend to have almost no influence on the day-to-day performance of the cap-weighted S&P 500 index.
- Financially– as shown in the example above, which index (cap weighted or equal weighted) performs better depends on the time frame and overall market performance. Historically, small stocks, have outperformed, larger stocks and this would give the edge to the equal-weighted index. Long-term data seems to support this as a study from 1926 to 2019 indicated that equal weight outperforms over long periods. According to Seeking Alpha: Over rolling 10-year periods, the largest outperformance for capitalization-weighting versus equal-weighting came in the ten years ending January 1991 at 6.2% per annum. This came on the heels of the longest underperformance for capitalization-weighting versus equal-weighting at 14.1% per annum for the decade ending in June 1983. Equal weighting produced absolute positive returns for each rolling 10-year period and outperformed capitalization-weighting about three-quarters of the time.
- Psychologically– equal-weighted indices are more meaningful in terms of diversification and cap-weighted indices more closely follow the S&P 500 Index. For most investors, it’s easier to follow cap-weighted indices in the news as they are most like the S&P 500 Index and are more publicized.
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Tax Concerns
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To maintain an equal weighting, Managers of equal-weighted indices must place many more trades. Each of these trades creates a taxable event for fund holders. In tax-free accounts (Roth IRAs) and tax-deferred accounts [Traditional IRAs, and 401(k)s] there are no current tax consequences. Accounts holders of non-qualified accounts will face a larger tax bill due to the more frequent trades.
In qualified accounts, either type of fund is a personal choice. The cap-weighted indices make much more sense in a non-qualified account due to tax considerations.
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Final Thoughts
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- Equal-weighted funds have outperformed cap-weighted funds over longer periods. But more recently, cap-weighted funds have outperformed.
- Cap-weighted funds are more recognized and publicized.
- Cap-weighted funds have less true diversification due to cap weighting.
- What is the correct answer? Like most things in life, it depends!
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