Get back in balance with equal-weighted indices

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published 2 December 2023

Top-down investors who worry about how much the top seven tech stocks now dominate the US market have two obvious choices.

The first is to avoid US stocks altogether. That may make sense tactically – for example, if you think that the gap between European and US stocks will narrow in the near term. However, for a longer-term asset allocation, it’s a very big decision to hold nothing in a country that accounts for about a quarter of the global economy, has the best record on economic growth and innovation, and shows a long history of delivering superior returns. Realistically, not many global investors are going to do that.

So the alternative is to use alternative weighting schemes – i.e., setting the proportion of each stock in your portfolio according to criteria other than market capitalisation. The simplest of these is equal weighting, where each company accounts for the same share of the index at the start, and is rebalanced back to equal weights at regular intervals (typically quarterly).

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MSCI USA and USA Equal Weighted Net total return, US dollar terms, June 1994=100

A tough decade for equal weighting

Over the very long term, equal weighting has tended to beat cap weighting, because it holds more in value shares and in smaller stocks – both of which have outperformed in the past. The last decade has not been kind to it – the big tech giants have kept outstripping the market and growing in influence and equal weighting has leaned against that. However, despite that, the MSCI USA Equal Weighted Index is still slightly ahead of the MSCI USA since 1994 (9.71% per year versus 9.45%), even after lagging by almost 3.5 percentage points per year over the past five years.

Index returns don’t always match well with what investors earn, due to trading fees, spreads and taxes, and equal weighting has a much higher turnover than cap weighting. So we need to see if products are able to track the benchmark closely.

The main option for UK investors is the Xtrackers S&P 500 Equal Weight (LSE: XDWE), whose annualised return over five years is 9.83% per year compared to a benchmark of 9.78% – ie, a very close tracking difference. Investors who want to favour US tech yet underweight the giants could consider the Invesco NASDAQ-100 Equal Weight ETF (LSE: EWQX), but this is a new fund and so we can’t check the tracking history (although there’s no obvious reason why it should be worse).

So should we employ an equal-weight fund for the US in our asset allocation strategy? There’s one argument against it: our portfolio is already weighted towards markets that we think offer greater value (Japan, emerging markets, Europe). Keeping a mega-cap tech bias in the S&P 500 may help balance our value approach against the tail risk that these firms keep growing to dominate the world economy due to breakthroughs in fields such as artificial intelligence. Set against that, valuations for big tech look stretched and history implies equal weighting may work well from here. So this is an option we’ll consider carefully once we’ve reviewed the rest of our positions.

This article was first published in MoneyWeek's magazine and all information was correct at the time of writing. Enjoy exclusive early access to news, opinion and analysis from our team of financial experts with a MoneyWeek subscription.

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Cris Sholto Heaton is an investment analyst and writer who has been contributing to MoneyWeek since 2006 and was managing editor of the magazine between 2016 and 2018. He is especially interested in international investing, believing many investors still focus too much on their home markets and that it pays to take advantage of all the opportunities the world offers. He often writes about Asian equities, international income and global asset allocation.

Cris began his career in financial services consultancy at PwC and Lane Clark & Peacock, before an abrupt change of direction into oil, gas and energy at Petroleum Economist and Platts and subsequently into investment research and writing. In addition to his articles for MoneyWeek, he also works with a number of asset managers, consultancies and financial information providers.

He holds the Chartered Financial Analyst designation and the Investment Management Certificate, as well as degrees in finance and mathematics. He has also studied acting, film-making and photography, and strongly suspects that an awareness of what makes a compelling story is just as important for understanding markets as any amount of qualifications.

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A tough decade for equal weighting

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