S&P 500 Equal Weight Index
The S&P 500 is dominated by the "magnificent seven" which creates significant concentration risk. The S&P 500 equal weight index offers a possible alternative.
The S&P 500 is the most common benchmark for large capitalization stocks in the United States. As its name implies, the index is comprised of 500 companies and covers approximately 80% of the total capitalization of the stock market.
A wide variety of mutual funds and exchange traded funds (ETFs) track the S&P 500 which makes it possible for investors to participate in the stock market at extremely low cost. For example, Vanguard’s S&P 500 ETF has an expense ratio of a microscopic three basis points, or 0.03%. Investing $1 million in the fund incurs an annual cost of only $300. In comparison, a typical 1% expense ratio for an actively managed fund would result in costs of $10,000 per $1 million invested. The cost advantage is one major reason for the rise of passive investing in recent decades.
As a market capitalization weighted index, the S&P 500 is highly concentrated in the very largest companies included in the index. For better or worse, investors who own the index will be disproportionately exposed to these mega cap stocks. Lately, the highest profile mega-cap stocks have been referred to as the “Magnificent Seven” which are comprised of Microsoft, Apple, Nvidia, Amazon, Meta Platforms, Alphabet, and Tesla. These seven stocks account for ~28% of the S&P 500. The exhibit below shows the top ten components of the Vanguard S&P 500 ETF as of December 31, 2023:
Is there anything wrong with being highly concentrated in the “Magnificent Seven” stocks? Not necessarily. In recent years, investors have been richly rewarded for owning these companies both directly and through index funds as they have come to dominate the stock market. It has been exceptionally difficult for investors who are not exposed to these companies to keep up with the S&P 500.
Investors who opt for a strategy that indexes to the S&P 500 should keep in mind that returns in the future are likely to be lower than returns over the past decade. I made the case that investors should reduce their expectations last month in Mr. Buffett on the Stock Market where I drew parallels between the conditions Warren Buffett wrote about in a Fortune article published in November 1999 and the current environment.
In December, I wrote about passive investing strategies and mentioned that I would investigate the topic this year. This is a vast subject. Investors are not at all limited to the S&P 500. One can track the total U.S. stock market, industry sectors, foreign markets, and many more esoteric indices. Many index fund investors have not adopted a fully passive approach. Instead, they are making bets on sectors or countries, hoping to outperform simple benchmarks like the S&P 500. In a sense, investors can use index fund products to actively manage their portfolio rather than be truly passive.
Those of us who recall the late 1990s will never forget the stock market bubble and subsequent crash. Warren Buffett’s article was published in the waning days of the bubble. While history never repeats exactly, it is hard to ignore the exuberance over artificial intelligence today and not compare it to the technology mania of the late 1990s. AI is likely to change the world just as the internet did, but there are limits to how high tech stocks can be bid up without compressing future returns.
What if an investor is concerned about the dominance of tech stocks in the S&P 500? If you invest $100,000 in the S&P 500, ~$28,000 will be invested in the “Magnificent Seven”. At least that is the case if you invest in a fund that tracks the S&P 500 on a market capitalization weighted basis.
There is another potential option: The S&P 500 Equal Weight Index. This index allocates approximately 0.2% to each of the five hundred companies in the S&P 500 regardless of the size of the company. The largest and smallest company included in the index are both treated equally. As a result, the “Magnificent Seven” accounts for just 1.4% of the S&P 500 Equal Weight Index. Concentration risk is eliminated, but the upside of continued outperformance of the “Magnificent Seven” is also eliminated.
Let’s take a look at the S&P 500 Equal Weight Index in terms of construction, industry concentration, and historical performance to better understand the risks and potential rewards of investing in this alternative to the standard S&P 500.
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The S&P 500 Equal Weight Index is designed to be a “size-neutral” version of the S&P 500. Every quarter, the index is rebalanced to allocate 0.2% of its weight to each of the five hundred components of the S&P 500. Between quarterly rebalancing, allocations to each component will vary based on performance of the underlying securities.