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Edition 78

For the last decade or so, investing in broad US equities has felt like a suspiciously easy path to returns. The tech giants of the S&P 500 have done much of the heavy lifting, with the top ten holdings now accounting for almost 40% of the index. This is great news when you’re on the right side of it and less great when these market darlings start to falter.

Concentration in the S&P 500 has climbed to levels rarely seen in modern history. This has revived interest in an equal-weighted approach to US equity indices. Instead of allocating more money to larger companies, an equal-weighted index gives every constituent the same starting allocation regardless of size.

There is a theoretical argument for why this approach should work over the long-term. Equal weighting pushes investors towards smaller companies, which financial academics have long suggested outperform larger peers. Therefore, some investors make the case that giving every company in the S&P 500 the same weight is arguably more aligned with the academic evidence.

Unfortunately, investing theories often remain just that - theories. While the evidence supporting smaller companies has been compelling in the past, the last decade in US equities has been defined by the opposite outcome.

The biggest companies keep getting bigger and expensive stocks become even more expensive. The investors who simply let the winners run were rewarded far more than those who took an equal-weighted approach.

It is also possible that the rise of passive investing may have contributed to this equation as money flows primarily into market cap weighted funds, automatically directing more money towards the larger companies.

Given this background, it’s worth asking whether there may be a better way to invest in the US market. Are you really buying exposure to 500 companies or simply a handful of tech giants with 490+ supporting acts?

The equal-weight version of the S&P 500 offers a counter proposition where it owns the same companies, but weights their allocation equally, no matter how large they are. In practice, this means a company like Apple with a market cap of 4.9 trillion USD, has roughly the same influence as Lululemon with a market cap of 11 billion USD.

Today I’ll look at one of the ASX’s largest equal-weighted US equity ETFs and examine why our analysts remain unconvinced that equal weighting is necessarily the superior approach.

BetaShares S&P 500 Equal Weight ETF QUS

  • Assets under management: $1.4 billion (AUD)
  • Morningstar category: Australia Fund Equity North America
  • Morningstar Medalist Rating: Neutral
  • Management fees and costs: 0.29%
  • Benchmark: MSCI USA NR AUD

QUS ETF replicates the S&P 500 Equal Weight Index, which pulls in all S&P 500 stocks and weights them equally at each quarterly rebalance.

To be included in the index, companies must have generated positive earnings for the most recent quarter and in aggregate, over the trailing four quarters.

At each rebalance, the strategy restores a 0.2% weighting for each holding. In between each rebalance, the company weights are dictated by stock price movements, capturing some of a stock’s rise as it trends, much like a market-cap-weighted index does.

Composition

While the traditional market-cap weighted S&P 500 allocates more than 20% of assets to its three largest holdings, this equal weight approach would require around 100 stocks to reach the same level of concentration.

It is rare for any position to become more than 1% of the portfolio. This substantially reduces company risk, which is where one stock’s misfortunes are less likely to derail the fund.

The equal-weight methodology naturally increases exposure to smaller companies within the S&P 500. As a result, the portfolio’s average market cap is far lower than that of the broader North American equity category.

For example, the category’s average market cap is currently around six times larger than QUS’. Our analyst notes this creates a persistent value tilt relative to both the category index and average peer fund.

Sector weightings also look very different to the average fund in this category. This is because sector allocations are determined by the number of companies in each sector, rather than their market value.

QUS carries significantly less exposure to tech than a traditional US equity index. At the end of June, the sector represented around 17% of the portfolio, which is less than half the MSCI USA Index’s roughly 40% allocation.

Costs

Trade-offs are the crux of investing and the choice whether to equal weight a fund is no different. On one hand, investors receive greater diversification, but they also face higher fees and less favourable tax outcomes. These are two costs that don’t exist to the same extent in traditional market-cap weighted ETFs.

The problem is that our investments don’t exist within a bubble. Most investors considering QUS are likely also considering a plain-vanilla S&P 500 ETF like iShares S&P 500 ETF IVV. The management fee on IVV is 0.04%, which places it among the cheapest funds in the category and gives it a significant structural advantage compared to QUS at 0.29%. A fee difference of 0.25% might not sound dramatic, but it does create a hurdle that equal-weighted performance must overcome.

The second cost is turnover. Constantly changing an underlying portfolio to maintain equal weighting results in higher turnover. Fund turnover represents the total value of securities the fund bought or sold (whichever is smaller), divided by the fund’s average assets over the year. The resulting percentage gives a sense of how much trading activity occurred within the fund overall.

QUS has a reported turnover of 4%, which is not traditionally considered high, however it is roughly 4x higher than its market-cap-weighted equivalent IVV ETF.

Two funds with similar pre‑tax performance can deliver very different outcomes simply because one trades far more than the other. Fund turnover is considered a proxy for trading costs. When a fund buys and sells it incurs the usual costs of brokerage and spreads. A higher turnover ratio indicates that more trading is occurring and less of the gross potential return is making its way to investors.

The quarterly rebalancing also may generate capital gains when shares are sold, with the gains being passed onto investors through distributions. This means you effectively bear the tax outcome even though you didn’t personally sell anything. Whether this matters depends entirely on the type of investor you are and your tax environment.

Performance

Varied performance has also reflected the trade-offs associated with equal weighting. Over the past five years, QUS has underperformed the MSCI USA Index by roughly 3.5% annualised. This is hardly surprising given the dominance of mega-cap tech stocks over that period. The fund’s structural underweighting to companies like Nvidia, Microsoft and Apple has been a significant headwind.

However, equal weighting hasn’t always been a disadvantage. When tech stocks struggled in 2022, the fund’s lower exposure to these companies provided meaningful downside protection with QUS outperforming the category index by more than 8% that year.

Its stronger performance more recently, with a year-to-date return of 7.06% compared with 4.95% for the category index, is largely why investors have once again become interested in equal-weight strategies.

As the market appears to be more cautious of the AI trade currently dominating market-cap weighted indices, an equal weighted approach has started to look more attractive.

Why do we rate it neutral?

Our analysts’ Neutral Medalist Rating reflects their belief that the benefits of equal weighting are largely offset by its drawbacks.

The strategy undeniably improves diversification and removes concentration risk. Its quarterly rebalancing process also creates a natural buy-low, sell-high effect, resulting in exposure to the value factor and less exposure to momentum. However, these come with meaningful costs.

Equal-weighting increases exposure to smaller, more volatile companies. It also requires more frequent trading which creates higher turnover and transaction costs and reduces tax efficiency. More importantly, these trade-offs have not delivered superior returns relative to cheaper market-cap weighted funds.

QUS offers a more diversified version of the S&P 500, but whether that diversification is worth the additional costs and active risk remains the central question for investors to consider.

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