May 31, 2024

Equal vs Capitalisation index investing – is there a winner?

Index investing is a great way to take stock picking out of the equation, while still providing a range of strategies to refine your investment preferences

Equal vs Capitalisation index investing

Index investing allows investors to participate in the stock market without having to pick individual stocks. It is a common strategy given its strong historical performance.

There are several variations to index investing. Two of these strategies are Capitalisation Weighted indexing and Equal Weighted indexing. Both have strengths and weaknesses and are impacted differently, depending on the current phase of the market cycle.

A Capitalisation Weighted index weights its constituent companies based on market capitalisation. An Equal Weighted index, in comparison, allocates an equal percentage of asset weighting to each security.

In the first three months of the year the S&P500 Index, which is a Capitalisation Weighted index, achieved a return of 10.16%. Meanwhile the S&P500 Equal Weighted index returned 7.39%¹. The difference in returns has been attributed to the first quarter outperformance of a few mega cap tech names, referred to as the ‘Magnificent 7’ – although recently that performance has come under pressure, leading the New York Times to pare back the performers to the ‘Fab 4’.

 

The performance story

Looking at relative performance in the first quarter the return from a Capitalisation Weighted index was clearly superior. However, in late March 2024, the S&P500 Equal Weighted index reached new highs. This was because the broader constitutes of the index started to catch up to the performance of the Magnificent 7. While the return was not as impressive as the return from our Capitalisation Weighted index example, there are other benefits offered by an Equal Weighted index.

For instance, as each security carries the same weight within an Equal Weighted index, each security has an equal impact on the index’s performance. This avoids the concentration risk inherent in a Capitalisation Weighted index, which has large cap companies dominating.

To explain by example, in the S&P500 Index, ‘The Magnificent 7’ represented approximately 30% of the Capitalisation Weighted index in the first quarter 2024², highlighting the risk that overall index return can be swung by only a handful of companies in a single sector.

Another benefit of an Equal Weighted index is that it’s less susceptible to valuation bubbles. Companies that outperform have an increased weight in a Capitalisation Weighted index. While this can drive significant index performance, it also can result in the index being tilted towards more expensive stocks. In comparison, Equal Weighted indexes periodically rebalance to avoid over allocation to expensive stocks.

Equal Weighted indexes allocate more to mid-and-small cap companies within the index. These companies may at times be more volatile than the overall market but may also offer the potential for higher returns. Historically, smaller companies tend to perform better during times of strong economic growth or accommodative monetary policy but tend to underperform during more uncertain periods.

 

What to consider with Index investing

Conditions in the market will determine which index strategy is preferred, but any strategy can be derailed by sudden, unexpected market events.

  • Most Equal Weighted indexes have higher expense ratios compared to Capitalised Weighted indexes, as bringing each security to equal weight involves more trades and therefore higher transaction costs.
  • An Equal Weighted index tends to outperform a Capitalised Weighted index when the market is trending upwards, and sentiment is positive.
  • A Capitalisation Weighted index tends to outperform an Equal Weighted index when there is a flight to quality or when a sector enters a perceived long term positive trend.

 

Accessing Equal Weighted index opportunities

One way to access an Equal Weighted index is through an Index ETF, and there are a few options available for investors to consider.  For example, BetaShares S&P500 Equal Weight ETF (QUS.ASX) and BetaShares Nasdaq100 Equal Weight ETF (QNDQ. ASX), provide exposure for Australian investors seeking access to US S&P 500 & Nasdaq companies in an equal-weighted manner. Both are traded on the ASX.

A similar strategy ETF fund tracking Australian listed companies is offered by VanEck Australian Equal Weight ETF (MVW.ASX), which invests in the largest and most liquid subset of Australian companies, and weights each security equally.

 

For those considering Capitalisation Weighted index opportunities

There are numerous opportunities for investors wishing to access Capitalisation Weighted index options in popular US indices. For example, Blackrock offers iShares S&P 500 ETF for both unhedged (IVV.ASX), and AUD hedged (IHVV.ASX) version. IVV.ASX is the largest on the Australian market.  Another S&P500 ETF in the local market offered by State Street is SPY.ASX.  For Nasdaq followers, BetaShares Nasdaq 100ETF (NDQ.ASX) enables investors to invest through the ASX in the largest 100 Nasdaq companies. It delivered an annual 52% return in 2023³, buoyed by tech sector outperformance.

 

Final word

There is no clear winner, as both strategies have their advantages and can be utilised to play to investors convictions on future market performance. Investors can also combine the strategies and have an exposure to both Equal Weighted Indexes and Capitalisation Weighted Indexes. This way investors can avoid falling far behind when price momentum runs out of stream, while still enjoying price gains during other periods in the market cycle.

 

To discover more call 1300 683106 or email us on investordesk@nab.com.au

 

¹Source:   S&P Global, Index Factsheets for S&P500 Index and S&P500 Equal Weight Index, Mar 2024.

²Source:  S&P Global, Commentary: US Equities Market Attributes Apr 2024

³Source: Betashares.com, Betashares Nasdaq 100 ETF (NDQ.ASX) Factsheet Apr 2024

 

Important Information

The information contained in this article is intended to be of a general nature only. It has been prepared without taking into account any person’s objectives, financial situation or needs. NAB recommends that you consider any relevant disclosure documents and seek independent financial and taxation advice before acting on any information in this article. Past performance is not necessarily indicative of future results. No warranty is made as to the accuracy, reliability or completeness of the information. Examples are illustrative only. To the extent permitted by law, neither NAB or any of its related entities accept liability to any person for loss or damage arising from the use of this information.

©2024 NAB Private Wealth is a division of National Australia Bank Limited ABN 12 004 044 937 AFSL and Australian Credit Licence 230686.

 

 

 

 

 

 

 

 

 

 

 

The information contained in this article is intended to be of a general nature only. It has been prepared without taking into account any person’s objectives, financial situation or needs. NAB does not guarantee the accuracy or reliability of any information in this article which is stated or provided by a third party. Before acting on this information, NAB recommends that you consider whether it is appropriate for your circumstances. NAB recommends that you seek independent legal, property, financial and taxation advice before acting on any information in this article. You may be exposed to investment risk, including loss of income and principal invested.

You should consider the relevant Product Disclosure Statement (PDS), Information Memorandum (IM) or other disclosure document and Financial Services Guide (available on request) before deciding whether to acquire, or to continue to hold, any of our products.

All information in this article is intended to be accessed by the following persons ‘Wholesale Clients’ as defined by the Corporations Act. This article should not be construed as a recommendation to acquire or dispose of any investments.

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