Coins in Stacks

Broad Equal-Weighted Index Funds: Interesting Idea, but Too Expensive

Coins in Stacks

Recently we've been getting questions from folks about broad equal-weighted index funds. Apparently some investors have noticed that an equal-weighted Wilshire 5000 index has outperformed the market-capitalization-weighted Wilshire 5000 and S&P 500 indexes.

S&P 500
Wilshire 5000
Wilshire 5000 equal-weighted
Source: Morningstar, data as of 7/31/2002         *annualized returns

The outperformance of an equal-weighted Wilshire 5000 is simply a reflection of what's been going on in the stock market the past few years. Large-cap stocks have, as we know, taken a beating during the bear market of the last three years. More exposure to small- and mid-caps in an equal-weighted index has softened the negative impact of large-caps.

Index weighting methodologies

There are three common systems for determining a stock's weight in an index: market-capitalization weighting, price weighting, and equal weighting. The names are fairly self-explanatory.

Most indexes used by investors today, including the S&P and Wilshire 5000, are market-capitalization weighted. A company's weight in an index is determined by its total market capitalization, or the share price multiplied by total shares outstanding. Therefore, the returns of large-cap stocks in the index play a much greater role in determining index performance than small- and mid-caps. When large-caps are in the market's sweet spot, their dominance is even more overwhelming.

In price-weighted indexes like the Dow Jones Industrial Average (DJIA), a stock's weight is determined by share price only. Although the DJIA has a long history and is still highly visible, most investors believe price-weighted indexes don't make great investments. For example, a company with expensive shares and a small market cap can greatly influence index returns.

In equal-weighted indexes, all stocks receive the same weighting regardless of their size or share price.

Let's take three hypothetical stocks to see how an index weighting methodology affects real returns.

Beginning share price
Ending share price
Stock return
Beginning market cap
Ending market cap
$100 billion
$75 billion
$20 billion
$24 billion
$1 billion
$1.3 billion

An index consisting of these three stocks would have different returns depending on which weighting scheme it used.

Weighting Method
Index return
Market-cap weighted

Again, since most indexes are market-cap weighted, big companies like Stock A greatly influence returns.

Equal-weighting: an index fund manager's worst nightmare

On the surface, it appears that an index fund holding an equal amount of all listed stocks would be the ultimate diversified fund. In fact, the first index fund, introduced by Wells Fargo in 1971, was designed to hold an equal dollar amount of all NYSE-listed stocks. However, the idea turned out be messy to implement, as described in Peter Bernstein's classic Capital Ideas:

" . . . the execution of the idea turned out to be a nightmare. Some stocks moved more widely than others, and a few moved in an opposite direction from the pack, so that the equal weighting would just not stand still. Heavy transaction costs were incurred for the constant re-weighting back to the original equal dollar amounts."

The ill-fated equal-weighted fund was later merged into an S&P 500 index fund.

What they really want

Probably the people interested in equal-weighted funds use one "total market" index fund for their equity exposure. They're likely unhappy with the fund's returns, and they've heard about the relative recent outperformance of smaller companies.

Total market index funds may have taken a drubbing, but they're simply doing what they're supposed to do: track market-capitalization weighted indexes. And as we've seen above, larger stocks are the main drivers of cap-weighted indexes.

Perhaps investors are also surprised by the correlation between the S&P 500 and total market index funds because TSM funds have so many more holdings, which may create the illusion of greater diversification. Vanguard's TSM fund holds many more names than its 500 index fund - 3,274 compared to 502, according to Morningstar.

However, let's look under the hood of Vanguard's S&P 500 index fund and its Total Stock Market (TSM) index fund that tracks the Wilshire 5000. As of the end of June, the Vanguard 500 fund held over 23% of assets in its top ten holdings, according to Morningstar. Vanguard's TSM index fund had the same names in its top ten, but about 19% of assets were parked in these stocks. Both indexes are concentrated in the biggest names, despite the number of holdings, because they are cap-weighted.

The breakdown for Vanguard's Total Stock Market index fund is roughly 70% large-caps, 20% mid-caps, and 10% small-caps. Believers in the TSM approach like Vanguard founder John Bogle like its simplicity, its low costs, and the fact that you're investing in "the market" as determined by all investors (cap-weighting).

Other investors deviate from the TSM concept and overweight smaller (or value) stocks with a slice-and-dice approach. An equal-weighted broad index fund would be the ideal vehicle for getting more small-cap exposure with only one fund, but unfortunately excess turnover makes this idea a practical impossibility.

S&P 500
1/3 S&P 500
1/3 S&P 400
1/3 S&P 600
Source: Portfolio Solutions, LLC (data as of 8/31/02)           *annualized returns

"Small-cap stocks have higher risk than large-caps, so on a risk-adjusted basis, does an equal-weighted portfolio outperform? I don't think so."