by Hussein Rashid, Invesco Canada
Last December’s sell-off and the more recent declines in the global equity markets serve as a reminder that the historic decade-long bull market for U.S. stocks cannot continue unchecked.
History tells us that sooner or later, these winning streaks will end. The magnitude and duration of such a decline is difficult to predict – will it be a temporary reaction to a president’s tweet, or a longer-term, recessionary decline? No one can say for certain.
The fear of missing out on potential future gains may entice some passive investors to hold onto their S&P 500 exposure. But at this point it may be prudent to reduce exposure to the market leaders that have powered this long-running bull market.
The problem with the standard S&P 500 index is that it is weighted by market capitalization. Its performance is disproportionally dominated by the largest company names.
As a small number of already large companies have skyrocketed, investors tracking the cap-weighted index have unwittingly increased their exposure to these winners. At the same time, they have been decreasing their exposure to companies that have lagged the overall index. Put another way, they have been buying high and selling low.
No one can accurately predict what the future holds for these mega-cap companies, but the fact remains that the cap-weighting methodology produces a portfolio that is far more concentrated than some may realize. The top ten constituents account for roughly 22% of the index, and six of them are within the technology sector.1
The cap-weighted methodology buys based on what has performed well in the past, regardless of future outlook. This leaves the portfolio prone to market bubbles and sentiment, as weightings chase returns notwithstanding the underlying business fundamentals.
Worse still, it has no sell discipline. It will not take profits on its winners and will only trim exposure to a given stock if it declines. So as the performance of the index tracks the security higher in a rising market, so too will the index performance disproportionately reflect the negative performance in a down market. In a worst-case scenario, the stock could be held until it is dropped from the index altogether.
However, there are alternatives to cap-weighting the index.
Equal weighting the same group of companies can dramatically reduce portfolio concentration risk and offers a more balanced portfolio than an investment that tracks the market-capitalization-weighted index, like the S&P 500.
An equal-weight portfolio with built-in rebalancing will periodically capitalize on the gains of market-leading companies, reinvesting the proceeds into lagging companies, which may offer potentially better value.
Historical performance data for the S&P 500 Equal Weight Index shows that it has consistently outperformed the market-capitalization-weighted S&P 500 over the long term.2
While this outperformance has been strongest through periods of recovery, the equal-weighting also tends to provide greater exposure to certain investment factors, specifically value and small-size and generally adds diversification benefits to more core U.S. equity allocations.
Many investors may now be considering a lower risk approach to U.S. equities. The increased diversification provided by exposure to the S&P 500 Equal Weight Index may represent a compelling alternative to a cap-weighted strategy.
Learn more about equal-weight strategies.
This post was originally published at Invesco Canada Blog
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