The fund type expected to win over more investors

The US market has become harder to beat over the past couple of years due to the continued outperformance of a handful of large-cap tech stocks.

Companies such as Microsoft (NASDAQ:MSFT), Nvidia (NASDAQ:NVDA), Amazon (NASDAQ:AMZN), Apple (NASDAQ:AAPL) and Alphabet Inc Class A (NASDAQ:GOOGL) now make up a huge percentage of the S&P 500 index. They have also outperformed the broader index. 

The so-called Magnificent Seven, which also includes Facebook-owner Meta Platforms (NASDAQ:META) and Tesla (NASDAQ:TSLA), now account for around a third of the S&P 500 and around 20% of the MSCI World Index.

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As the weightings to the seven stocks rises, the performance of the index becomes more reliant on their fortunes. Most index funds and exchange-traded funds (ETFs) are market-cap weighted, which means the companies are weighted according to their total value relative to the index.

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Equal-weight ETFs

An alternative option to reduce concentration risk is to consider index funds and ETFs that track 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.

According to The Financial Times, equal-weight ETFs are expected to become increasingly popular for those seeking US stock market exposure as some investors become more wary of concentration risk. 

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.

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

However, there 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 Acc GBP (LSE:SPEX) and Xtrackers S&P 500 Equal Weight ETF 1C USD (LSE:XDEW).

Both rebalance the stocks quarterly, taking profits from winners that have increased above the 0.2% weighting, and topping up those that have fallen below the 0.2% weighting. The yearly charges for the ETFs are the same at 0.2%.

Each individual share will generate 0.2% of the returns achieved by these two ETF as a whole. 

How have the two equal-weight ETFs performed?

As one would expect, the two equal-weighted ETFs have lagged index funds and ETFs that are market-cap weighted.

The data below compares the performance of five US index funds or ETFs, since November 2021, which was when Xtrackers S&P 500 Equal Weight ETF was launched for UK investors.

Invesco S&P 500 Equal Weight was launched for UK investors in April of the same year.

Source: FE Analytics. Past performance is not a guide to future performance.

The performance gap between Invesco S&P 500 Equal Weight ETF and Xtrackers S&P 500 Equal Weight ETF over this three-year period is notable. It serves as a reminder to investors that the performance of index funds and ETFs is not identical when tracking the same index.

The tracking error for Xtrackers S&P 500 Equal Weight ETF was higher. Tracking error looks at the standard deviation of daily returns of a portfolio compared to that of the underlying index. Basically, it is a measure of how often, and how wide, the performance of the portfolio deviates from that of the index.

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However, over one year performance is a lot closer, with Xtrackers S&P 500 Equal Weight ETF having the edge in returning 25.3% versus 24.4% for Invesco S&P 500 Equal Weight.

Just a short-term play?

Is deciding that now is the right time to switch out of a market-cap weighted to an equal-weighted fund purely a short- or medium-term decision?

After all, it would be very bold to bet against US larger companies, including the technology giants, over the long term.

Figures from FE Analytics show that the S&P 500 has outperformed the S&P 500 Equal Weighted index over both 20, 10 and five years.

While over the next five, 10 and 20 years it is anyone's guess whether this trend will persist, it is perhaps prudent to hedge your bets by considering an equal-weighted ETF as a complementary holding rather than your sole holding for the US stock market.

Source: FE Analytics. Past performance is not a guide to future performance.

Concentration risk for some index funds and ETFs 

An index fund or ETF tracking the S&P index on a market-cap weighed basis, such as Vanguard S&P 500 UCITS ETF and iShares Core S&P 500 ETF, have around a third in the Magnificent Seven. Both ETFs have low yearly ongoing charges of 0.07% a year.

Naturally, a technology-focused passive fund will have higher weightings to the seven companies. L&G Global Technology Index, for example, has a 16.2% weighting to Apple, 15.3% to Microsoft, and 13.5% to Nvidia.  

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Invesco EQQQ NASDAQ-100 ETF (LSE:EQQQ) has smaller individual weightings, with its top holding, Apple, accounting for 8.6%. However, its overall exposure to the seven companies accounts for 44%. 

Another passive fund with big weightings to the US technology behemoths is L&G Global 100 Index Trust. The index it tracks holds multinational blue-chips of “major importance” in global equity markets. The result for the fund is big weightings to five of the Magnificent Seven: Apple (accounts for 12.3% of assets), Nvidia (11.6%), Microsoft (10.7%), Alphabet (6.6%), and Amazon (6.2%).

Other global index funds and ETFs hold less in US tech. For example, Fidelity Index World has 21.8% allocated to the Magnificent Seven in its top 10 holdings.