The S&P, our old friend.
If you’ve read any of our articles about investing, odds are you’ve seen some mention of the S&P 500. The Standard & Poor’s 500 is a stock market index, or a compilation of companies that investors can view at a glance to get a sense of how the broader economy is doing. It’s often what people are referring to when they talk about “the market.” In particular, the S&P 500 tracks the stocks of 500 large, mostly U.S.-based companies.
Today’s topic is close to our hearts because we generally recommend that our readers invest in stock market indexes rather than in individual stocks.
That’s why, today, we want to talk about the “other” S&P 500.
A Little Background
People invest in the S&P 500 through index funds or ETFs (exchange-traded funds) that follow it. Most mutual funds are "actively-managed," which means that a person is trying to choose investments that will outperform the stock market. Index funds, on the other hand, go for the tie rather than for the win by mimicking the investments contained in the index and simply buying them in those same proportions. Because this investing is “passive,” index funds can charge much lower operating fees than traditional mutual funds.
ETFs act very similarly to index funds, but tend to have even lower fees. Which is why we like them.
The regular S&P 500 weights large companies more than little ones. When we say "large," we're talking about market capitalization, which is a measure of how much money a company is worth (by multiplying all the company's shares out in the world by the price per share). So, company A and company B could both be included in the S&P 500, but if company A has a way bigger market cap, it will count more toward the index’s total composition.
But, as this article points out, there’s another way to do the S&P.
The 'Other' S&P 500
The S&P 500 Equal Weight index tracks the same companies as the normal index, but gives every company an equal weight. For example, in the regular S&P 500, the ten largest companies make up almost 20% of the index; in the equal weight version, they only make up about 2% of the total.
The equal weight S&P 500 index was created in 2003 by Standard & Poor's. This version of the S&P 500 hit a high last May, and is close to hitting another. Over the past five years, it’s returned about 1.75% per year, compared to -0.25% in the regular S&P index. That’s a pretty significant difference.
So why don’t we all just invest in the equal weight index instead?
Is the Equal Weight Index Better?
The S&P 500 isn’t designed to maximize returns—it’s designed to reflect what the market is like. (And yet we invest in it because the mutual funds that try to maximize returns often fail and charge high fees for the privilege. Over time, taking fees into account, tracking the stock index usually comes out on top.)
The equal weight index is another way to approach a similar problem. Here are the pros and cons of the equal weight S&P 500:
It tends to have higher returns in harder economic times: The average company size is smaller, since this index isn’t weighting the big fish as heavily. Smaller companies tend to have higher risk factors but also more potential for growth during a bear (or downward-trending) market. In a bull market that is experiencing upward growth, however, the regular S&P 500 does better.
You’re less at the whim of bubbles: The regular S&P 500 tends to expose investors more to stock bubbles, since it gives fast-growing stocks a higher weight. After all, when a company is doing well, it is worth more, and therefore its market cap goes up. For example, the regular S&P 500 would have given you higher returns than the equal weight index during the 90s tech boom, but it would have given you worse returns during the bust years.
Higher risk: The equal weight index’s emphasis on smaller companies increases your total potential risk. As we pointed out above, small companies often have more room for growth, but they also may be less stable.
Higher fees: For example, the Rydex S&P 500 Equal Weight ETF (RSP) charges operation fees of 0.40%, whereas its regular S&P counterpart, SPDR S&P 500 ETF (SPY), charges only 0.09%. That's because the equal weight ETF requires more upkeep by managers, and has higher turnover. When we’re talking about large sums of money, this can add up.
Too much weight on sectors with a large number of companies: For example, during the recession, financial companies took a big hit, so they shrank in the regular S&P 500 because it’s weighted by size. But, in the equal weight index, they are still equally represented.
It's harder to buy: The equal weight ETF may be harder to procure than its S&P 500 counterpart, because not all brokerages have sales agreements in place to offer it. To see if your brokerage offers this kind of ETF, search its online database for an S&P 500 equal weight ETF.
So … Should You Do It?
One of the most important underlying principles of investing is not to put all your eggs in one basket (more technically, “Diversify, people!”). Do not abandon your traditional S&P 500 investments completely—if possible, include both the regular kind and the equal weight in your portfolio.
Remember that the equal weight index is riskier than the regular S&P 500, so bear in mind your tolerance for risk. If you’re young and investing for the long term, you might split your large cap U.S. stock investments between the S&P 500 and the equal weight index halfsies—if you want to be aggressive about returns, you might even skew more toward the equal weight index. Conversely, if you have a shorter time horizon, you can still invest in the equal weight index but will want to hold more of the traditional S&P 500 than its equal weight counterpart.