S&P 500 ETFs: Market Weight Vs. Equal Weight

By Ken Hawkins AAA

In January 2003, the S&P 500 Equal Weight Index (EWI) was created. As the name implies, this is an equal weight version of the popular S&P 500 Index. Although both indexes are comprised of the same stocks, the different weighting schemes result in two indexes with different properties and different benefits for investors. There are also exchange-traded funds (ETFs) that track each of the two indexes. The Rydex S&P 500 Equal Weight ETF (ARCA:RSP) tracks the EWI; the ETF of choice for the S&P 500, is the State Street SPDR S&P 500 (ARCA:SPY).

Let's take a look at each type of index, the ETFs that track these indexes and how the type of weighting of the index you choose can affect your investments.

Indexes 101
Similar to many stock indexes, the S&P 500 is a market capitalization weighted index. The market capitalization of each stock is determined by taking the share price and multiplying it the number of shares outstanding. The companies with the largest market capitalizations, or the greatest values, will have the highest weights in the index. The weight of a company in the index is equal to the market cap of that company divided by the total market cap of all the companies in the index. For example, in March 2012, the total market cap of the S&P 500 was $12.7 trillion. The largest company in the index was Apple (Nasdaq:AAPL), with a market cap of $546 billion. Its weight in the index therefore was 4.3% of the total index.

An equal weighted index is just as it sounds. Every stock in the index has the same weight, regardless how large or small the company is. Therefore, even Apple will have the same weight (0.2%) as the smallest company that is a constituent in the S&P 500.

In the table below, we have shown a calculation of a hypothetical five-stock index, comparing a market weight versus an equal weight calculation.

Stock Return % Mkt. Weight % Equal Weight % Contribution Mkt. Weight Contribution Equal Weight
ABC 4 50 20 2 0.80
DEF 3 30 20 0.90 0.60
GHI 7 10 20 0.70 1.40
JKL 4 7 20 0.28 0.80
MNO 12 3 20 0.36 2.40
Total - 100 100 4.24% 6%

Figure 1: Equal weight versus market weight index performance

small-cap stocks, the S&P 500 EWI Index has different sector exposures compared to the S&P 500 as well. The sector weight of a MWI is calculated by summing up the individual weights of the companies that will make up that sector. For EWI, the sector weight is really a direct function of the number of companies in the sector. For example, if a sector contains 45 stocks, then the weight of the sector should theoretically be (45 / 500) x 100 = 9%.

The different weighting schemes will result in different sector exposures. The table below shows the difference in sector weight between the two indexes as of Dec. 30, 2011. For example, in the EWI, the consumer discretionary sector had a weight of 16% but only 10.70% in the MWI. In the MWI, energy was 12.30%, but because there are only 43 stocks, the weight in the S&P 500 EWI is only 8.60%. Understanding the difference in sector make-up will help to determine which index to use.

Sector No. of Companies S&P 500 % S&P 500 EWI %
Consumer Discretionary 80 10.70 16.00
Consumer Staples 42 11.50 8.40
Energy 43 12.30 8.60
Financials 82 13.60 16.30
Healthcare 52 11.90 10.50
Industrials 61 10.70 12.20
Information Technology 70 19.00 14.00
Materials 30 3.50 6.00
Telecommunications 7 3.00 1.40
Utilities 33 3.90 6.60
Figure 2: Sector weight comparison as of Dec. 30, 2011

Turnover
In terms of each respective index, the normal market weighted S&P 500 does need to be periodically adjusted, but not rebalanced. There will be adjustments to reflect companies that have been removed and new companies that have been added to the index. There will also be adjustments made as companies in the index issue new shares or retire existing ones.

For the S&P 500 EWI, the goal is to maintain a portfolio of 500 equally weighted stocks while keeping index turnover to a minimum. Each stock in the index is assigned a weight of 0.20% (1 / 500 x 100). The S&P 500 EWI is rebalanced quarterly to coincide with the quarterly share adjustment of the S&P 500, which takes place on the third Friday of each quarter. Shares of stocks that performed well in the previous quarter will be sold and those that did relatively poorly will have to be bought to assure the equal weight, which is essentially a sell high, buy low strategy. However, the rebalancing will result in additional trading costs for the ETF. From 2002 to 2008, the amount of average annual turnover for the EWI version of the S&P 500 was about 22%, versus 4% for the S&P 500 Index.

Volatility
Volatility tends to be higher on the S&P 500 EWI versus the S&P 500. For the five years ending December 2007, the annualized standard deviation was 10.97% for the S&P EWI versus 8.61% for the S&P 500.

This reflects the fact that smaller-cap stocks are generally more volatile than larger companies, and the S&P 500 EWI has a greater tilt toward small-cap stocks than the S&P 500.

Performance
A study done by Srikant Dash and Keith Loggie of Standard & Poor's in 2008 analyzed the performance of the S&P 500 and the S&P 500 EWI. Since 1990, the EWI has outperformed by 1.5% per year but not consistently. It lagged the S&P 500 for six consecutive years from 1994 to 1999, but outperformed the S&P 500 for seven years through 2006. The study suggested that the EWI appeared to underperform the S&P 500 during strong markets, but held up better during bear markets. The result also suggests that when value stocks outperform growth stocks, the EWI will outperform the S&P 500.

Comparing ETFs
The Rydex S&P Equal Weight ETF has been traded since April 2003. At the end of March 2012, its total assets were $3.08 billion. Its expense ratio was 0.40%. The SPDR S&P 500 ETF has been traded since January 1993. At the end of March 2012, it had $99.60 billion in assets and an expense ratio of 0.09%. In comparing the two, the greater asset and lower expense ratio would suggest that the SPY is more liquid and less expensive than RSP; it also had a lower turnover.

The Bottom Line
Currently it's possible to trade ETFs that represent both the traditional S&P 500 MWI and the newer equal weight S&P 500 index. Although both indexes are comprised of the same stocks, the different weighting schemes results in two indexes with very different properties.

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