There is a difference in returns between the market capitalisation weighted S&P 500 index ETF (SPY) and the equal weighted ETF (RSP) which is worth exploring. A simple look at the top 5 companies in the S&P 500 (which is a market capitalisation weighted index) shows that Apple, Microsoft, Amazon, Tesla and the two Google share classes make up 21.9% of the weight of the index. The chart below shows two ETFs (indexed basis). RSP (equal weight index) has outperformed SPY (market cap. index) by a wide margin since mid-2003, which long-term investors should note.
Chart of RSP and SPY ETF indexed
The table below shows recent return figures which illustrates the recent differences between the two.
The year-to-date difference is worth noting, but the benefits of having exposure to the market weight index is clear in the 9% difference over the 5-yr. return.
Index construction and math
What is the difference between a market cap. weighted index and an equal weighted index tracking the same shares? Market cap. for indices is usually determined by the number of ‘free floating’ shares multiplied by the share price. The ‘free float’ figure can be tricky at times as some countries have ‘golden shares’ and there are sometimes issues about closely held (dominant family or owner) shares which may or may not be considered ‘free floating’. The official S&P index methodology can be read here. Once the rules of what goes into the index are figured out, the next issue is the math. The S&P indices math methodology can be read here. For UK investors the FTSE Russell index policy and methodology information can be found here.
Varying returns from same stocks, different weights
Once all the methodology and math are absorbed – what is the bottom line for investors? There are certain rules of thumb in the stock market. One is that bigger risk (or volatility of returns) can give bigger returns. Smaller companies are seen as a ‘bigger risk’ and can offer bigger returns. An equally weighted index could outperform a market cap. weighted index. The other rule of thumb is that momentum is hard to beat. Shares that are going up can indeed continue to go up. A market cap weighted index, in a stock market cycle that is rewarding ‘winners’ may outperform an equally weighted one.
The chart and table above show the annual returns of the different ETFs. The relative ‘small company’ effect does seem to kick in at recovery parts of the investment cycle. RSP outperformed in 2004/2005 and again in 2009/2010 and then 2012/2014 and 2016. Trying to determine which part of the investment cycle the market is in can be tricky though.