Know Which Weighted-Index Fund to Choose
Investors who like to play the odds often invest in passively managed indexed funds. This way, they grow their assets gradually along with expanding the US and world economy. But what exactly is a passively managed fund? For those who don’t know, a passively managed fund is one when the investment securities are not selected by a portfolio manager. Instead, they are selected automatically in order to match an index or a certain part of the investment market.
If you go back in time, almost 18 years ago, there was no concept of such passively managed funds. The only way to invest passively was via capitalization-weighted index funds. Such a fund invests in the same stocks that are already in an unmanaged index. It then owns a proportion of the fund according to market capitalization or the number of shares times its price. Therefore, investors own high-performing large stocks in greater amounts than smaller or medium-sized companies.
The S&P 500 Equal Weight Index (S&P 500 EWI) turned the index fund industry upside down with this novel way of investing back in January 2003. The equal-weighted index fund divides each of the stocks in the investor portfolio equally. Therefore, under this index, investors own the big Apple and tiny Stericycle in the same proportions.
Equal-Weight Index Funds Support Small Companies
No doubt, both of these investment approaches give an investor enough diversification. However, a market-cap-weighted index approach yields different returns than an equal-weighted index approach. This is because the underlying holdings are owned in different proportions.
The market cap index funds favor larger and outperforming stocks. In contrast, the equal-weight funds offer greater exposure to smaller and medium firms. “Performance results aside, we don’t believe either of these approaches is better or worse than the other – they just work differently,” says Kirsty Peev. She is the portfolio manager at Virginia-based, Halpern Financial.
Both kinds of funds have their own set of advantages and disadvantages, according to financial experts. In the following paragraphs, we will be looking at some of these from the lens of market analysts and experts.
Shawn Johnson, ex-chairperson of the investment committee at the State Street Global Advisors and founder of Guidon Global, an investment firm based in Boston, admits that the market cap bias in index funds favors large firms. According to him, the reason behind this favoritism is that the market cap performs as a proxy for liquidity. Because of this reason, it becomes much easier to trade in stocks of large companies than the shares of smaller ones.
Today, investors are less concerned about liquidity. This is because most of the stocks in both of these indexes are already liquid, Johnson says. Equal weighted Index funds just remove the large-cap bias due to which investors get a lower weighted average market cap. Though each style of investment outperforms sometimes, experts favor smaller – yet fast-growing – companies than bigger ones in a market weight index.
Vijay Vaidyanathan, the CEO of California-based Optimal Asset Management, says, “A major disadvantage of having a cap-weighted portfolio is that these funds become riskier because of excessive fund accumulation in the large firms. He believes an advantage of equal-weighted index funds is that it’s a quick way to get better asset diversification of rewarded risks. It also cuts back on the unrewarded risks.
When an investor invests in stocks, they expect higher returns for riskier assets. However, when more and more investors pour their money into fewer shares, the market cap weight index funds become inherently riskier. Therefore, it can be rightly said that equal weight index funds support smaller firms and companies.
Market-Weighted Index Funds Can Have Drawbacks
Investment experts believe market-weighted index funds are overweighted in firms that are outperforming the market for the time being and concentrated in few sectors only. This method works extremely well when large firms are on a tear. However, in the long run, market-cap-weighted index funds have major drawbacks.
Steven Jon Kaplan, the CEO of True Contrarian Investments based in New York, believes so. According to him, the financial markets are cyclical in nature. Various firms go in and out of favor all the time. Because the cap-weighted index funds buy more large caps, they inherently lean towards popular firms and invest a lot less in less popular companies. In the long run, this causes it to underperform compared to a fund with the same shares in equal weight. This is because, at some point in time, any company that is overvalued has to return to its fair market value.
Market Weight index funds can be equated with momentum investment strategy. Under this strategy, investment is made in stocks that are growing. It leads to the reality that the market cap weight index fund’s top ten holdings make up over twenty percent of the fund’s entire value. Sure, this is a great investment when the winners keep on growing. However, it’s not so good when they crash – which is inevitable. Remember what happened back in the late 1990s? Most of the tech favorites became overvalued and came crashing down to the ground in what is now known as the dot com bubble.
On the other hand, equal-weighted index funds are based on value. This approach prefers undervalued stocks that have some potential to rise to a fair value. For instance, when shares in firm A grow in value, a portion of these shares will be subsequently sold and deployed into a low-priced company B. So that equal weight-age of all the companies in the indexes can be maintained. This leads to more sales. It also has some potential tax consequences. Nevertheless, the performance data so far favors the equal weight model of funds.
The research also supports the assertion that equal indexes outperform market-cap indexes over the long term. Moreover, the long-term studies of both types of funds show similar outperformance by the equal-weighted index funds.
So, the bottom line of the entire debate between equal vs. market weight funds is that both approaches have their own pros and cons. However, with more diversification and a value bend, the equal-weighted index funds outperform the marked weight index funds in the long run. But keep in mind, the higher management expense ratio of the equal-weighted funds can eat up the returns. If you are an investor looking to overweight the popular and top-performing firms, the market weight index fund seems like a more appropriate option.
Last but not least, in the bulls market, when the larger firms are outperforming smaller ones, investors should expect a market-cap-weighted index fund to offer better returns.