Long term data suggest that investors can beat the market by holding the same stocks as those included in the S&P 500, if given equal weighting. This according to Validea CEO John Reese in last week’s Globe and Mail.
Since stocks in the S&P 500 index are weighted according to market capitalization (larger proportions represented by bigger companies), Reese points out that some equal-weighted funds with the same holdings have outperformed the benchmark. He writes, “The equal-weight strategy covers for a few flaws in the market-cap style. It keeps the investor from overinvesting in hot, expensive and overbought stocks.”
Also, because equal-weighted funds rebalance frequently to maintain the stock mix, Reese says, “the index methodology has a systematic mechanism that results in funds being allocated to stocks that have sold off, effectively bringing them back to equal weight, and taking money off the table of the stocks that have gone up.”
These types of funds can struggle when, for example, there are a small number of big companies leading the market performance. However, writes Reese, that allows investors to “get rewarded on the back side when the average stock starts to perform much better.”
Using Validea’s quantitative system, Reese outlined which S&P 500 stocks might currently be weighted the most heavily based on fundamentals compared to the actual current weighting in the index (see below).
He notes, “Investors who want a rules-based approach to passive investing and understand the downside to market cap weightings, but want to beat the S&P 500 at its own game, might want to consider an equally weighted approach.”