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.
Subscribe to MoneyWeek
Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE
Sign up to Money Morning
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
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.
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.
-
Rightmove: Asking prices edge closer to record peakAsking prices have been driven up by the top-end of the market, Rightmove has found. But how does the situation look in your area?
-
Coventry Building Society bids £780m for Co-operative Bank - what could it mean for customers?Coventry Building Society has put in an offer of £780 million to buy Co-operative Bank. When will the potential deal happen and what could it mean for customers?
