From time to time, stock market indices become dominated by small groups of stocks. In 1999 and 2000, for example, TMT (technology, media and telecommunications) shares made up a big chunk of the FTSE 100, with Vodafone alone constituting nearly 14% of the index.Financial stocks were similar in 2007/2008.
If you are tracking a capitalisation-weighted index (where a company's weighting grows with its market value), this kind of concentration should concern you. It often happens when a bubble is forming, leaving you overly exposed to the most vulnerable sectors ahead of any fall.
There's a simple way to deal with this. Instead of weighting by market capitalisation, an index can allocate each company an equal weighting. This results in a much smaller weighting for the largest stocks, while companies at the other end of the index get a boost.
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Today, for example, five companies account for 30% of the FTSE 100 Royal Dutch Shell, HSBC, BP, GlaxoSmithKline and BAT. But in an equal-weighted version of the FTSE 100, each would get a 1% weighting.
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FTSE 100 minnows such as Fresnillo, Sports Direct and TUI Travel, whose weightings are currently around 0.1% of the index, would see a tenfoldincrease.
This approach automatically boosts the presence of smaller stocks, making this type of tracker a cheap alternative to an actively managed smaller companies fund.
But equal weighting has another benefit. Companies' index weightings don't stay fixed: they drift due to share-price movements.This means that index firms must regularly rebalance their equal-weighted benchmarks (to keep each holding at 1%), which means selling winners and buying losers.
Thisbuy low, sell high' policy makes sense and it's almost the opposite of what capitalisation-weighted indices do (where the pricier a stock gets, the bigger its weighting within the index).
There are no London-listed exchange-traded funds (ETFs) on the equally weighted FTSE 100 yet, but two ETFs offer exposure to European and US shares. Ossiam's L6EW and db X-trackers' XEQD track equally weighted versions of the Stoxx 600 and S&P 500 indices respectively.
You pay a bit more (typically 0.1%-0.15%) in annual fees for an equal-weighted ETF than for a traditional tracker. But for a long-term investor, the approach is worth a look.
Former fund manager Paul Ameryis a freelance journalist.
