S&P 500 ETFs: Market-cap or equal weight?

Index construction methodologies 

Modern index funds tend to be constructed in one of two ways:

1. Price weighted: Each stock included in the index is weighted proportionately to its stock price. Therefore, a stock with a higher price is weighted more than a low-priced one and has a greater influence on the index's performance. An example of a price weighted index is the Dow Jones Industrial Average.
2. Market-cap weighted: Each stock included in the index is weighted proportionately to its market capitalization, which is share price times the number of outstanding shares. Therefore, a stock with a higher market cap is weighted more than one with a lower market cap and has a greater influence on the index's performance. An example of a market-cap weighted index is the S&P 500.

Equal-weighted index ETFs disregard these two methodologies and instead hold all the companies in a particular index at equal weights. Consider the following example:

• A regular market-cap weight S&P 500 ETF would hold Apple (AAPL) at a 7.05% allocation.
• An equal-weight S&P 500 ETF would hold AAPL at a 0.20% allocation, given that there are around 500 stocks in the S&P 500.

Beyond individual stocks, equal-weighted index ETFs also tend to have a more even allocation between different stock market sectors, market capitalizations, and styles (growth, value, blend, etc).

Head-to-head

I've provided a backtest of two S&P 500 ETFs below:

• SPDR S&P 500 ETF (SPY): 0.09 expense ratio.
• Invesco S&P 500 Equal Weight ETF (RSP): 0.20% expense ratio.

A backtest from May 2003 to present shows RSP outperforming in terms of CAGR, but with higher volatility and drawdowns, with an overall poorer Sharpe ratio.

In terms of annual returns, we see notable divergences in 2009, where RSP outperforms (likely due to better mid-cap and defensive sector performance following the 2008 crash), and so far in 2022, thanks to its lower allocation to hard-hit tech stocks.

Let's look at exposures now. We see that compared to SPY, RSP has a much higher allocation to both mid-cap value and growth stocks, which can allow investors to capture additional exposure to the size risk factor. This can increase the potential for returns, albeit at higher volatility.

Finally, the sector allocations in RSP are much more balanced compared to SPY. We see a much more even distribution between consumer cyclical, financial services, healthcare, and industrials. Technology no longer dominates the holdings like it did in SPY.

Are equal weight index ETFs worth it?

The answer to that question depends on your thesis on whether or not the markets are efficiently priced. From a passive investor point of view, I want to invest in the market as it is at the moment. This means accepting the market-cap weights of various stocks as they rise and fall. Investors who subscribe to this approach will receive the average of the market's return (net of fees), but nothing more or less.

Investors who think the market is inefficient may want to use an equal-weighting methodology to capture the returns of sectors, market caps, or styles they think are currently undervalued and ready to resurge. Keep in mind that this is an active management approach, regardless of whether or not you use an index ETF. This requires being able to stick to it, especially during years when it underperforms a market-cap weighted fund.

Personally? I like to keep it simple. This means finding the most broadly diversified, lowest cost ETF. Market-cap weighted funds like SPY tend to be much cheaper, have better liquidity (volume, assets under management, bid-ask spread), and lower fund turnover. Still, if you want a more "even" ETF, RSP is a pretty good way of capturing that.