david and goliath fight

In an equal-weight strategy, such as the one employed by the Invesco S&P 500 Equal Weight Index ETF, the mightiest names are cut down to size.

Just two U.S. companies — technology giants Apple Inc. and Microsoft Corp. —make up close to 14% of the S&P 500 Index. But in the equally weighted version of this broad market benchmark, their weights are slashed to just 0.2% each.

The same goes for the other so-called Magnificent Seven: Amazon.com Inc., Nvidia Corp., Alphabet Inc., Tesla Inc. and Meta Platforms Inc. They get the same 0.2% weighting as, for example, Domino’s Pizza Inc.

The result for equal-weight investors — for better or worse — is a portfolio that’s much more broadly diversified by name, but far less exposed to the market leaders. When market gains are driven primarily by a select few large companies, equally weighted strategies will underperform, as has been the case this year.

Over the 12 months ended Aug. 31, the Invesco ETF returned 11.6%, a healthy enough return. But it lagged a market-cap-weighted competitor, the iShares Core S&P 500 Index ETF, which returned 19.4% over the same period. Over five years, iShares also outperformed, returning an annualized 11.5% versus the equal-weight Invesco’s 9.4%.

But during the three-year period, which included a steep downturn for the heavily weighted technology sector, Invesco’s equal-weight version of the S&P 500 returned 13.3% annually, outperforming the iShares return of 11.6%.

With more than 30% of the S&P 500 Index occupied by the 10 largest companies — mostly technology names — one advantage of an equal-weight strategy is to manage concentration risk, said Darim Abdullah, vice-president and ETF strategist with Toronto-based Invesco Canada Ltd.

Secondly, Abdullah said, equal weighting is a way to manage valuation risk. “As the concentration of the top names becomes higher, that means that their valuations have stretched. So it gives investors a way to manage valuation risk that tends to be prevalent in the S&P 500.”

The S&P 500 is more growth-oriented in nature, given the hefty combined weight of the Magnificent Seven. “The equal-weight strategy gives you that tilt toward the value investment style,” Abdullah said. “Taking it back to portfolio construction and diversification benefits, these are considerations that advisors look into as they build their portfolios for the U.S. equity asset class.”

Thirdly, equal weighting enables investors to increase their exposure to the smaller but still well established companies that make up the bottom of the S&P 500. “You have a different exposure to them, given the 0.2% weighting to every stock,” said Abdullah, “so that [provides] a healthier, higher allocation, which allows you to tap into that potential outperformance.”

Historically, since the launch of the S&P 500 Equal Weight Index in early 2003, the bottom 50 index constituents have outperformed the largest 50. Through the end of June, the annualized return of the bottom 50 was 11.3%, or 2.4% higher than the top 50, Abdullah said. The smaller stocks may be slightly more volatile, “but in the long run it does provide that diversification benefit.”

While Invesco also offers the Invesco S&P Europe 350 Equal Weight Index ETF and the Invesco NASDAQ 100 Equal Weight Index ETF, other equal-weight ETFs in Canada are focused on industry sectors. The largest equal-weight lineups — in sectors such as energy, financial services, health care and real-estate equities — are those of Oakville, Ont.-based Harvest Portfolios Group Inc. and BMO Asset Management Inc.

Unlike Invesco, BMO doesn’t offer equally weighted ETFs based on broad markets. In these asset classes, said Alfred Lee, portfolio manager and investment strategist with BMO ETFs, BMO has found that the demand for alternative weighting methodologies has been more toward factor-based strategies such as low volatility or high dividends.

“We take an equal weighting where it makes sense,” Lee said. “For example, when you look at a lot of the Canadian sectors, they tend to be highly concentrated.”

BMO’s most prominent example is the $3.9-billion BMO Equal Weight Banks Index ETF. It holds stocks of the six largest Canadian banks, which are reset to 16.7% each when rebalanced semi-annually. Based on market capitalization, Royal Bank of Canada and Toronto-Dominion Bank would have a combined weighting of about 57%.

Lee said most investors in a sector-based ETF want exposure that doesn’t involve making bets on individual stocks, and that’s what BMO is trying to deliver. “That’s where we take an equal-weighting approach, when there’s a concentrated sector and there’s not a lot of constituents, or if the sector tends to be very top-heavy.”

Another advantage of equal weighting is that “it’s almost a natural buy-low, sell- high strategy,” Lee said. “Between now and the next rebalance period, what’s going to happen is we’re going to let the winners run.” Subsequently, the portfolio is rebalanced by selling some of the winners’ shares and repositioning to those stocks that have lagged during the six-month period.

For Harvest, which offers 16 ETFs that employ covered calls to generate tax-efficient capital gains, equal weights make it more efficient to execute its options strategies, said Paul MacDonald, chief investment officer. Harvest portfolio managers generally write covered calls on up to 33% of the portfolios, which hold large-cap liquid stocks of leading companies in their sectors.

Whether for broadly based or sector mandates, the performance picture is mixed when comparing equal weight to market-cap strategies. “When the breadth is wider and more stocks are participating, you’ll generally get better performance out of an equally weighted strategy, all else being equal,” said MacDonald, whose ETFs are mostly equally weighted.

Though there’s no sure thing, there are reasons to believe that current market conditions favour equal weighting. Going back over 29 years of calendar-year data, MacDonald said, the year to date has seen the second-widest outperformance of the cap-weighted S&P 500 index versus its equal-weight counterpart.

As for valuation, MacDonald said the price/earnings ratio of the equally weighted S&P 500 is currently near its lowest relative to the cap-weighted S&P 500 since 2010. He said an argument can be made that the second-widest relative underperformance in nearly 30 years, coupled with low relative valuation, may favour an equal-weight strategy.