When It Comes to Diversification, Don’t Be Naïve (Part 2)

Equal-weighted index vs mid-cap index?

Ben Johnson 22.12.2016
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In part 1 of this article, we looked at how equal-weighting the S&P500 has performed, let’s explore further.

Case Closed?

Not so fast. While equal weighting addresses concerns related to single stocks, sectors, and so on, its predominant effect on the composure of the index’s portfolio relative to its cap-weighted parent is to give greater weightings to smaller stocks. According to S&P Dow Jones Indices, the top 10 constituents of the S&P 500 accounted for 18.1% of the index’s value as of Sept. 30, while the top 10 stocks in the equal-weighted version accounted for just 2.2% of the index’s value. Over the long term, this skew toward smaller-cap names has yielded greater returns relative to the cap-weighted S&P 500 at the cost of relatively greater volatility. In other words, from a diversification, risk, and return perspective, the equal-weighted S&P 500 looks an awful lot like a mid-cap portfolio.

Pay No Attention to the Mid-Cap Fund Behind the Curtain

At first blush, the equal-weighted S&P 500 bears a striking resemblance to a mid-cap fund, but what do the numbers tell us? The EW/400 line in last week’s Exhibit 1 plots the relative wealth generated by an investment in the equal-weighted S&P 500 versus the S&P MidCap 400 Index. The result is starkly different from the relationship between the equal-weighted S&P 500 and its cap-weighted parent. For much of the past 15-plus years, the equal-weighted S&P 500 and the cap-weighted mid-cap indexes have been in a dead heat, as evidenced by the flatness of the EW/400 line over that span. That said, the mid-cap index has outperformed the equal-weighted S&P 500 during the past 25 years.

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About Author

Ben Johnson  Ben Johnson, CFA is the Director of Passive Fund Research with Morningstar.

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