Invesco Insights Live

Hello, and welcome to an Invesco ETF Insights webinar.

I'm Tom Digby, Head of ETF Business Development and Capital Markets here in the APAC region.

And I'm delighted today to be joined by Tim Edwards, Global Head of Index Investment Strategy at S&P Dow Jones Indices.

Thank you, Tim, for joining us today.

Hi Tom, Thanks for having me.

Great.

So before we dive into it today we're going to be looking at the S&P 500 equal weight index.

So better understand whether as the title suggests, it is really worth its weight. Now, as some of you may be aware, the S&P 500 equal weight Index has outperformed the S&P 500 over more than two decades of live history.

(Source: Invesco, as of 10 September 2024. Past performance is not the guide to future returns.)

Now, now in this session, we're going to look at some of the drivers of that performance. But, but firstly, you know, why are we talking about this strategy today?

Well, we're currently seeing sort of high levels of concentration risk in large cap US equities with the top ten names accounting for, you know, upwards of 35% at times of the S&P 500.

(Source: Invesco, as of 10 September 2024.Past performance is not guide to future returns)

If you couple this with, you know, historically mega cap has been seen to be less volatile than smaller names.

This has really flipped in more recent times, and we can come on to that a bit later on.

We've seen this play out even more recently within the last month or so with particular company results dampening down sort of analyst expectations on stock price, which has been a catalyst somewhat of a perceived wider market volatility.

So Tim, can you share with us a brief introduction to the equal weight strategy in your thoughts on how this fits into the current market environment?

Absolutely.

And let's see if I can get the technology to work to at least start with an introduction.

OK, so please be introduced if you've not met it before.

The S&P 500 Equal Weight is a in its 3rd decade of live performance.

It is a reassuringly simple index.

It went live on January the 8th, 2003 and it has a back test.

And all back tests should be judged with a degree of cynicism.

But the design of this index does give me a little bit more confidence in its back test than in some others.

And that's because it is a very, very simple index.

What it takes the constituents of the S&P 500 and it weights them equally.

So each of the 500 companies gets a weight of one 500th of the index.

Obviously, once you set up that that portfolio, some stocks will be better than others.

They'll come to take larger, smaller positions within the portfolio.

And if you want this to remain an equal weight strategy, eventually you have to rebalance.

The rebalance on the equal weight index is on a quarterly cycle tied up with the general S&P 500 index rebalancing.

So you're potentially taking advantage of greater liquidity in the underlying that occur around the time at a top level , as a benchmark considered as a, you know, a reference benchmark.

We'll talk about it as an investment a bit later.

It measures the performance of the average stock, the S&P 500 cap, traditional capitalization weighted index that measures the overall performance of all the dollars invested in the market.

It is the performance of the average dollar invested in the S&P 500, the equal weight index, this is precisely true in between rebalances.

It gives you the performance of the average stock.

So that's what it is.

We will get into in a bit more detail how it is generated that out performance, what kind of drivers it has.

But I may pause there and say that's the index.

That's how it works.

Reassuringly simple, I hope.

Yeah, makes  a lot of sense.

So you know, as I mentioned right at the top, we're seeing sort of high levels of concentration risk in the S&P 500 today leading, you know, a lot of investors concerns out there.

Can you give us a bit of more detail around that concentration risk?

You know, where are we now?

How's that been reflected historically as well as the performance associated with that?

Yeah, exactly.

Look, there are a lot of different ways that people can measure concentration or concentration risk.

Here's, here's one that I think is very tangible or was very tangible for me and it's simply to look at, you know, what's the average size on a sort of constituent weighted basis, what is the average size of the companies you've invested in?

OK.

On at the end of the Q4, if you took all the S&P 500 companies and you asked what is their average market cap, the answer you would get is just under $100 billion and $96.3 billion. (Source:  S&P Dow Jones Indices, Q2 2024)

But if you look at a capitalization weighted index, which obviously puts higher weights in larger companies, the index weighted average market capitalization was nearly a trillion dollars, that is 10 times as large. (Source:  S&P Dow Jones Indices, Q2 2024)

And this sort of ratio, thinking about this in terms of a ratio, how large are the companies on average in capitalization weighted index versus equal weighted index?

That's something that you can then measure over time and gives you something that sort of inflates equally as companies get bigger.

In the late 60s, early 1970s, there were similar levels of concentration.

It is unusual and it is a level of concentration that we haven't seen for 50 plus years.

In terms of overall weighting in the top, I'll just say I'm passing two things and then I'll get on to an important consequence.

First thing is look, this is not just about the S&P 500.

This is a phenomenon of the US stock market.

It's nothing to do with, you know, which companies in particular in the S&P500 all the fact that we've  ended our list at 500 companies rather than you know, 4000 or so listed stocks.

It's a feature of the US market.

It's been driven by an increases in the very largest names and measures of concentration that look at the top one, the top five, the top ten.

They are also at similar levels of extremes of concentrations and there is a very natural and intuitive relationship between trends and concentration and the relative performance of equal and capitalization weighted strategies.

And just to outline that before I prove this to you graphically, what happens?

How does concentration increase?

Most natural way for concentration to increase is that the very largest companies get bigger.

The way for concentration to decrease is that the smaller companies get bigger at a faster rate than the larger companies.

Now intuitively, there's already a really strong connection between capitalization weighted and equal weighted performance.

The differential in performance is going to be driven by the relative performance of larger, smaller companies.

And if you sort of plot this out, you will find a, reassuringly negative relationship between the relative excess return of equal weights in total return terms versus capitalization weighted.

And hopefully visually you can see confirmation here in terms of, you know what's  driving  the simplest driver of equal weight relative performance.

It's concentration and trends in concentration in the short term are really closely connected.

However, something that is also worth stressing is note over this and this is you know, including the back test, but you can see it, it's still working in the live.

Over the past 21 years or so over the full period.

Yeah, that makes perfect sense.

One of the questions we're getting a lot from investors at the moment and especially within the last year-to-date when these trends may reverse, you know, what are your thoughts that could cause these trends to reverse and what might we see going forward to where we are in the market currently?

Yeah, and there's look, there's a lot to unpack in that.

Let me let me untease three things, right.

So I want to I want to talk about the general environment for momentum.

I want to talk about the relative performance of the very largest and the rest of the stocks.

And I want to talk about a change in the winds that we might have seen that that happened around that the year's halfway point.

But starting with the notion of momentum trends.

So we have an index that represents the performance of a basic long only trend following strategies over a medium range on the S&P 500.

So the S&P 500 momentum index, it's an index of 100 constituents with the strongest process of price trends.

And it's, it's basically a one year time horizon that was that's got nearly 10 years of live history and is relatively simple.

So you can sort of back test it again back to the 1970s.

And what I want to highlight here is or emphasize something that I think this audience already knows, which is first of all, momentum as a strategy generally could have positive performance, certainly over, you know, medium terms like a one year period.

So this chart showing you 12 months trailing returns.

It's mostly above zero.

But when it reaches extremes, which it did in the late 70s, which it did during the technology bubble and in historical terms, which it did very recently, it has quite bubblish behavior.

A very short spike and then a sharp reversal.

And I don't want to, you know, overstate the importance of a couple of historical events, but historically, momentum overall has been quite extended within the S&P 500 historical extensions momentum have tended to accompany reversals.

And what's been driving this particular momentum trend is it's very dominated by the tech sector, tech and communications and it's very dominated by the very largest among stocks.

And that generally is a reason that many investors have some disease degree of anxiety around the S&P 500 or around the largest, the largest names in the S&P 500.

So that's momentum.

The second piece is,  an observation that the very largest stocks have started to pave a little bit differently to the rest of the market.

Tom mentioned earnings and we are seeing overall a phenomena of higher dispersion, more idiosyncratic risk in the overall markets.

I wanted to pick something that took a super long term perspective and identified something surprising.

So this is looking at the correlation between S&P 500 equal weight and 10 year U.S.

Treasuries or S&P 5/10 year U.S. Treasuries.

And for most of their history, you couldn't tell the difference.

Look, these are both broad diversified baskets of 500 companies and their correlations to treasury yields historically were almost indistinguishable.

But initially  in the COVID pandemic and again, more recently, we're starting to see differentiated behavior in terms of sensitivity to the, rate and the yield environment in the very largest names versus the rest of them, which suggests that this decision in terms of capitalization and equal weighting is potentially more important than it usually is from a total portfolio perspective.

And the last thing I wanted to highlight and look, this is relatively early. Things have started to move in another direction.

Way too early to stay with us, you know definitive.

But coming into 2024, that long term cyclical trend that we've been seeing since 2014 of outperformance from the very largest stocks, outperformance from of capitalization versus equal weighting, outperforming of large caps versus mid and small caps.

That continued at very, very strong levels.

But we have H2 here, it's actually around mid-July, something flipped and we're seeing a reversal in that pattern, all of which adding together.

So the overall level of concentration, the extension in momentum trends, the differentiated reactions to macro factors like interest rates and the fact that there does appear to be at least initial signs of a potential change in the winds, I think makes equal weight particularly interesting to evaluate right now.

Yeah, so that's some great points there.

And I think, you know your momentum point is really going to be valuable for investors to really look at the performance of those of those strategies, especially with that natural inverse relationship you mentioned.

And when we think about risks as well, interestingly in a separate study that  we did here at Invesco, we looked at each stocks volatility and their correlation within the S&P 500 to calculate how much each one of those names drives overall risk.

And the high volatility of the top ten names have really pushed the contribution to risk to a really high level where you know at the moment half the uncertainty or risk in the S&P 500's one year return is actually caused by those top ten names on a look back basis.

So that's really led our investors to look towards this sort of equal weight strategy to provide them not only diversification benefits of the  equal weight strategy, but tilting towards low volatility.

And we'll come on to various different factors a little bit later on.

But an interesting point that you mentioned there as well, that's the S&P 500 continues to be driven by the select few names.

And you know we'd expect the benchmark to act more in line with that sort of idiosyncratic risks associated by doing that.

And as you can see here, you know, finally we've got this last few months.

So we've seen this sort of market trends type reversing.

So that sort of puts us into the current market context.

But taking a more sort of longer term historical view on this, how do you sort of see the relative performance playing out, especially versus large mid and small cap peers in this space?

And then we'll go on to maybe breaking down to performance figures after that.

Tim.

Yeah.

Look, it's, a, it's a dynamic that is I think quite fundamental to understanding what's going on in the broader U.S.

equity market at the moment.

That the results you say about how much been driven by the largest stocks doesn't surprise me.

There are also other indicators that you can look at, if I may, if I briefly go off topic, you know, there's the VIX (Volatility Index) which is a measure of, the price of market volatility.

There's also a dispersion index DSPX (Cboe S&P 500 Dispersion Index), which gives you the price that like the relative price of single stock options.

The spread between those two is higher than it's been for a long time all over the market.

You are seeing signs of idiosyncratic risk being at a much higher volume, even to the extent that, you know, the, the morning wraps what you read to understand what happened in the market yesterday used to be all just, you know, what people think the Fed are doing now , it's far more like individual.

It's about, you know, what happened to Facebook or what happened to NVIDIA or what happened to and rightly so like those the the idiosyncratic risk component, the volume has been turned up.

（For illustrative purpose only. This is not investment advice）

If you turn to longer term, there are still observations that I suspect will remain true in terms of your smaller companies having more of a value bias, more of a connection to the US domestic economy and more connection to kind of the broader macro factors.

But yeah, to the extent you were asking for my thoughts of a reaction to the research that investigate put out.

Yeah, that's very consistent with what we.

OK, great.

So we, we sort of touched on there about the current, the current market context, but let's take a look sort of further back now really go into the drivers of some of the performance here.

Can we just touch on just to set the scene historically how does equal weight outperform versus its sort of large mid and small cap peers?

Yeah, absolutely.

So and I will, I will brief advertisement.

So a lot of what I'm about to show you is also available in a paper that we published a month and a bit ago called Worth the Wait.

And we'll go through a few of those, a few of the analytics that we did that look at different factors driving that long term outperformance.

So over the full period since it went live, the total return of the equal weight index was 11 1/2 percent.

(Source: S&P Dow Jones Indices, as of 30 June 2024. Past performance is not the guide to future returns.)

Over the full period.

It outperformed the S&P 500.

But those trends over the past 5,  10, 15 years of increasing concentration mean that it is underperforming the S&P 500 over those periods versus small caps and versus mid caps especially got positive excess return over all those time horizons because they did not share the same, you know, mega cap perspectives.

Should I keep going Tom or do you want to?

Yeah, I think that's yeah, , please you carry on.

So  the sort of the next piece in terms of understanding the long term performance and one of the most surprising results was actually the following.

Look, if you look at the historical composition of equal weight versus capitalization weighted, you will notice and this shouldn't surprise you that in the late 90s there was a much higher allocation in the tech sector in capitalization weights than equal weight.

Rolling into 2006, 2007, there was a much higher allocation to the financial sector in the capitalization weighted versus equal weighting.

And that might lead you to suppose that a lot of the long term performance drivers in equal weight are from sector exposures.

However, although that's quite true in the short term  in terms of understanding forms over a month or quarter sector perspective that quite a lot of insight.

If you do a long-term attribution analysis and we update this on a monthly basis, I should say in, dashboards that are available for anyone over the long term, nearly all of the excess return came from equally waiting within each sector.

And actually the overall sector weighting that equal weight had compared to, you know, the differential in sector weightings actually contributed negatively to the total returns.

Source: S&P Dow Jones Indices LLC, FactSet. Data from March 31, 2003, to June 28, 2024. Index performance based on total return indices in USD.

I think that's  super important from a sector perspective.

Yes, there are there are differences and that has results.

But in terms of understanding the excess return that is observed overall and is definitely really strong if you control concentration, it comes from equally weighting within each sector.

Source: S&P Dow Jones Indices LLC, FactSet. Data from March 31, 2003, to June 28, 2024. Index performance based on total return indices in USD.

So that to me was a surprising result.

Less surprising to move from a kind of sector to factor perspective.

Less surprising is the role of size, right, in terms of a factor driving returns.

I'm going to state something super obvious here.

Equal, the equal weight index compared to the S&P 500 has an exposure to smaller size.

It's still large cap stocks, but smaller large cap stocks.

And just kind of illustrating this look reassuringly, the equal weight index has on average 80% allocation to the bottom 400 companies.

(Source: S&P Dow Jones Indices, as of 30 June 2024.)

That makes total sense as of the end of June.

This is kind of gives you that direct comparison.

Tom was mentioning 30 odd percent in the top 10, 56% in the top 50.

You know two more than 2/3 in the market cap index is in the top 20, 20% of stocks.

Sources: S&P Dow Jones Indices LLC. Data as of Jun. 28, 2024. Past performance is no guarantee of future performance.

So you'd expect size to have a big factor.

So just  as a final point, Tim, how well would equal weight really go up against sort of active managers in this space in general?

Yeah.

So this is, this is something we, we added to the to, to the research really for the following reasons.

So what I've been talking about all the way through is managing concentration risk or managing concentration, the discipline of rebalancing.

And in this last section, actually talking about capturing a greater share of returns from individual outperforming stocks.

And these are all reasons that people might look to an actively managed strategy, again, not, slavishly following a capitalization, waiting, avoiding concentration, the discipline of rebalancing, participation in hero stocks.

These are absolutely reasons that people will look to an actively managed approach in, US equities.

And it won't surprise the audience, I think to know that.

So we, we as we Dow Jones indices does a regular school cards on actively managed funds.

How many are beating the S&P 500?

What was their average performance?

It's called speed up.

We've been producing that for 20 years.

And so we were able to run back in time and say, OK, if we look at US actively managed mutual funds and look at their average performance year on year versus the S&P 500, does their performance look a little bit like equal weight?

And reassuringly it's look, it's not a perfect match.

There's a lot going on there.

But there is a correlation.

And generally speaking, when equal weight does better, that tends to be, you know a sign of a tailwinds for stock pickers.

When equal weight does worse that since we headwinds for stockpickers and that in some sense goes all the way back to the observation at the beginning about equal weight being the performance of the average stock , right.

How do you judge a stock picker?

Do they do better rather than picking a stock at random?

What's the performance of picking a stock at random?

Expected to be the equal weight return?

And I think that's a context in which I think equal weight as well as being potentially on an alternative benchmark than you know, the S&P500 index, I think there are grounds to suppose that this is also something to consider as a comparison to  actively manage stock picking funds.