Ask ii: is this a smarter way to play the S&P 500?

A reader asks: “The world’s biggest technology companies are driving most of the performance of US stock markets. To reduce risk, is it more prudent to invest in an equally weighted exchange-traded fund (ETF) over the more common market-cap weighted approach?”

Kyle Caldwell, collectives editor at interactive investor (pictured above), says: As you’ve noted, most major indices, such as the FTSE 100 and S&P 500, all use market-cap weightings, which rank companies by their size.

The market cap of a company is the total number of shares in existence multiplied by the price of those shares. If a company’s share price goes up relative to other members of the index, it represents a higher percentage of the index.

Therefore, when there’s a narrow set of winners in an index over a certain time period, those companies become more influential.

This has played out year-to-date for America’s largest technology companies. Hype around the future potential of artificial intelligence has boosted the share prices of America’s seven big tech stocks this year, the so-called Magnificent Seven.

So far in 2023, chipmaker NVIDIA (NASDAQ:NVDA) is up 230%, Facebook-owner Meta Platforms (NASDAQ:META) has risen 162%, Tesla (NASDAQ:TSLA) has gained 144%, Alphabet (NASDAQ:GOOGL) is up 57%, while Amazon (NASDAQ:AMZN), Apple (NASDAQ:AAPL), and Microsoft (NASDAQ:MSFT) have respectively advanced 56%, 45% and 38%. 

• Be cautious of ‘AI tech hype’ as seven US stocks dominate returns
• How Nasdaq-100 ‘special rebalance’ has impacted the big seven tech stocks

As the weightings to those seven stocks rises, the performance of the index becomes more reliant on their fortunes.

To address the risk of over-concentration, a couple of months ago the Nasdaq-100 index implemented a “special rebalance”. The index, which is market-cap weighted, reduced the weightings of those seven stocks from around half of the index to 43%. For the S&P 500 index, the weighting is around 30%. For the MSCI World index, the weighting is less, but still significant, at around 17%.

This means a lot of single-stock risk for those with exposure to index funds or ETFs that follow the up and down fortunes of a market-cap weighted index.

In contrast, risk is spread far and wide with an equal-weighted index, which holds each company in equal proportion. For example, an equal-weighted FTSE 100 index would have a 1% weighting to each constituent.

One of the main benefits is that an equal-weighted ETF avoids being overexposed to stocks that have become overvalued, or worse still potentially part of a bubble.

Another plus point is that an equal-weighted index offers more exposure to parts of the market that have performed less well in recent years. Going forwards, if there’s a broader set of winners in US markets then this approach will, in theory, capitalise on that more than market-cap weighted indices.  

The trouble is there’s much less choice in terms of index funds and ETFs tracking an equal-weighted index. Examples on interactive investor include the Invesco S&P 500 Equal Weight ETF, and Invesco NASDAQ-100 Equal Weight ETF.

Since it launched in April 2021, the Invesco S&P 500 Equal Weight ETF is up 15.3%. It has lagged the Vanguard S&P 500 ETF, which is up 24.9%, and follows the market-cap weighted approach. However, due to the dominance of those seven technology stocks year-to-date, it is unsurprising that the Vanguard ETF has had the upper hand over the period.