Why consider an S&P 500 equal weight strategy?

Prior to 2023, the S&P 500 Equal Weight total return index (Equal Weight) outperformed the S&P 500 total return index (S&P 500) by an average of 0.87% annually from inception.¹ However last year Equal Weight underperformed the S&P 500 due to the outperformance of the Magnificent 7 group of companies. These stock returns resulted in the S&P 500 reaching record concentration and valuation levels.

While the underperformance in 2023 was notable, we outline three compelling reasons why we still believe investors should consider an Equal Weight strategy.

1. High concentration: Over the past year the top 10 names in the S&P 500 have contributed to over half of its volatility, a level significantly higher than the 35% contribution seen during the dot com bubble.² As of August 2024, the top 10 companies in the index accounted for 34.5% of the S&P 500 market capitalization.³ As concentration in the index has hit multi-decade highs, an increasing number of investors are raising concerns over concentration risk.
2. Stretched valuations: The P/E ratio of the Bloomberg Magnificent 7 index was higher than that of the S&P 500 Index at the end of August - 37.57 versus 25.95.⁴ The high valuations of mega-cap growth names have pushed the P/E ratio of the S&P 500 to a 25% premium to the Equal Weight index. This trend has pushed the S&P 500 to be “growth-like,” with its constituent overlap with the Nasdaq 100 Index doubling over the last 10 years.
3. Mean reversion of excess returns: Historically, performance mean reverts over time and therefore the current environment may offer a potential tactical opportunity. Equal Weight is recovering from its worst 12-month relative drawdown in the past 20 years and during August Equal Weight outperformed the S&P 500 by 0.07%.⁵

Why Equal Weight?

The S&P 500 Equal Weight total return index equally weights the stocks in the S&P 500. Its quarterly rebalancing schedule imposes a strict “buy low, sell high” discipline. At rebalance, the index trims exposure to stocks that performed well during the quarter (sell high) and increases exposure to stocks that underperformed (buy low). Relative to market cap indexes like the S&P 500, this reduces the concentration towards mega-cap companies.

Many of these mega-cap names are highly volatile and the average name in the top 10 has a 28% trailing one year volatility, nearly double that of the S&P 500’s overall volatility (12.7%).⁶ Historically mega cap companies were less volatile than smaller names in the S&P 500, but in recent years this relationship has flipped.

Another way to think about this risk is that half the uncertainty in the S&P 500’s 1-year return was caused by the top 10 names. This has caused Equal Weight, which equally weights the S&P 500, thus diversifying across all 500 names, to have a low volatility tilt relative to the S&P 500. For those concerned about concentration risk in the S&P 500, Equal Weight’s diversification and current low volatility tilt could be a potential solution.

The Equal Weight strategy can therefore benefit from:

• Reduced concentration risk relative to the capitalization-weighted S&P 500 (largest companies in the S&P 500 Index make up the most exposure in it);
• Inexpensive valuation relative to the cap-weighted S&P 500 Index; and
• Reversion tendency following notable recent underperformance.

Investment Risks

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