The growing concentration of index funds into the largest companies has drawn increasing criticism, particularly from proponents of active management. This critique echoes familiar arguments about an “index investing bubble,” a topic we’ve explored previously.
As with any perceived problem in finance, there is of course a product to solve it. For concerns about concentration risk in index funds, the proposed solution is Equal Weight ETFs. These funds claim to offer better diversification than traditional market-cap-weighted options while also presenting the potential for outperformance.
Problems with Market Cap-Weighted Indexes
Most index funds are market cap-weighted, meaning each company’s allocation in the index is proportional to its market value. The highest value companies will be the highest holdings and vice versa.
To illustrate, these are the current top 10 holdings of an S&P500 index fund:
The top 10 holdings currently account for over 37% of the entire index, leaving the remaining 490 companies to make up the rest.
Critics argue that this concentration creates a significant risk, particularly since 7 of these top 10 companies are in the tech sector, making their performance closely related.
While active management is often presented as a way to mitigate such risks, its high fees and persistent underperformance have done little to dissuade retail investors from index funds. Instead, a different investment product claiming to offer the best of both worlds has been gaining traction: Equal Weight ETFs.
Equal-weighted ETFs
Equal-weighted ETFs continue to invest in the largest 500 U.S. companies (in the case of the S&P 500) but allocate holdings differently than a traditional index fund. Instead of weighting companies by market capitalisation, these ETFs distribute holdings equally.
Theoretically, this means each company would represent 0.20% of the portfolio, whether it’s Apple, Tesla, or Ralph Lauren (currently ranked 471st by market cap). This approach shifts the index from being heavily weighted toward the largest companies to a more balanced distribution across large, medium, and (relatively) smaller shares.
Proposed Benefits
By allocating to smaller companies, an equal weight index is naturally shifted toward the value factor. The value factor is a well-researched phenomenon in investing that says that companies that are cheaper (lower price-to-book value) will outperform larger, more expensive companies. Because of this, an equally weighted ETF should outperform its cap-weighted counterpart. Back testing supports this: the S&P 500 Equal Weight Index has historically outperformed its market cap-weighted counterpart since 1970.
The strategy is also marketed as a solution to the risks associated with traditional index funds’ concentration. Critics claim that a heavily top-weighted index is overly reliant on the continued growth of its largest constituents, a pattern that may not be sustainable.
Equal-weight ETFs, therefore, promise a combination of diversification, value exposure, and cost efficiency, potentially offering a middle ground for investors concerned about concentration risks in market-cap-weighted indexes.
Are They Worth It?
As with any financial product, the claims behind equal-weighted ETFs warrant scrutiny.
Historical vs. Recent Performance
While proponents point to 50 years of historical outperformance, the story is less compelling in recent years. Over the past decade, the S&P 500 Equal Weight Index has underperformed its market cap weighted counterpart by over 2% per annum. This underperformance stems from the value premium, on which equal-weight strategies heavily rely, falling out of favour. Despite extensive research showing that cheaper companies should outperform more expensive ones, this hasn’t been true on aggregate for the last decade.
Will the value factor come back? Possibly. But such a turnaround could take 10 or 20 years, and investors must ask themselves if they’re willing to endure prolonged underperformance for a payoff that is hardly guaranteed.
By contrast, traditional index funds are designed to adapt. Underperforming large companies are continually replaced by better-performing smaller ones. History supports this dynamic. For example, IBM, the largest company in the S&P 500 during the late 20th century, now ranks just 36th.
The Momentum Problem
Perhaps the biggest drawback of equal-weight ETFs is their negative tilt toward another critical factor: momentum. Momentum describes the tendency for successful companies to continue performing well. It’s as intuitive of a factor as value is but is completely ignored by these strategies.
To maintain equal weighting, these ETFs must regularly sell shares of well-performing companies and reinvest in underperformers. It is best personified by a quote from famous investor, Peter Lynch:
“Selling your winners and holding your losers is like cutting the flowers and watering the weeds”.
This rebalancing process not only sacrifices the benefits of momentum but also will incur higher transaction costs due to the frequent rebalancing required to maintain equal weight.
Value Premium vs. Market Efficiency
It’s important to note that tilting toward the value premium isn’t about beating the market, even if it results in outperformance. Instead, value investing just represents a riskier approach. Smaller companies, which are usually overrepresented in value strategies, are more prone to bankruptcy and greater volatility than larger companies. The theory is that this added risk is rewarded with higher returns over the long term, but that doesn’t mean traditional index funds are inferior.
Interestingly, many value investors still adhere to the concept of market efficiency: the idea that all available information is already reflected in market prices. Unlike typical active investors, they don’t believe large companies are overvalued. Instead, they target smaller, cheaper companies in pursuit of higher net returns.
Ironically, value funds that follow this rules-based, market-efficient approach are often priced similarly to equal-weight ETFs. This similarity in fees undermines one of the key selling points of equal-weight strategies, their supposed cost advantage.
Summary
Like many things in the finance world, equal weight ETFs seem to be a product that solves a problem that arguably doesn’t exist.
For those that believe in market prices, the argument for concentration risk in index funds wouldn’t concern you. After all, if the market has priced them this way, they should be largely correct. If instead you believe these companies are overpriced and that the market is wrong, you would not be suited to index-based products in the first place and would better be served by typical active management.
Similarly, equal-weight strategies poorly serve value investors. Their inherent negative tilt toward momentum contradicts the principles of value investing, where returns are often generated by holding smaller companies based on fundamentals until they grow into larger ones. It is the exact strategy that made Warren Buffet a billionaire. Selling the winners and buying the losers simply doesn’t align with the philosophy of value investing.
In essence, equal-weight ETFs attempt to straddle two investing styles but fail to satisfy either. For those interested in value-based strategies, there are already low-cost, rules-based options that align better with this philosophy. For investors seeking simplicity and trusting the efficiency of markets, conventional index funds remain more accessible, cost-effective, and widely available.
