Advisors and investors typically allocate to index funds and exchange traded funds linked to well-known benchmarks, such as the S&P 500, in the name of diversification. After all, these funds are homes to hundreds of stocks and those sizable rosters imply some level of diversity. However, a market capitalization-weighted fund’s diversification properties can be diminished when market values surge on the back of bull markets. That’s been the case this year and during the prior bull market and those scenarios underscore the diversification benefits of equal-weight ETFs, including the Invesco S&P 500® Equal Weight ETF (RSP).
Owing to the performance of the magnificent seven stocks – a cadre of consumer and technology names – a small number of equities are commanding out-sized percentages of the cap-weighted S&P 500, reducing the diversification properties of the index and the ETFs that track it.
“First, investors in the S&P 500 Index may think they are getting exposure to a diversified basket of 500 companies,” noted Lisa Shalett, Chief Investment Officer, Morgan Stanley Wealth Management. “But the top 10 mega-cap companies in the index have accounted for as much as 35% of its entire market capitalization in recent months compared with an average of 20% over the past 35 years. This means that money deployed into the S&P 500 is increasingly a wager on the health of just a few companies—with the fundamentals of the other 490 carrying less weight.”
RSP Has Diversification Goods
When it comes to mitigating single-stock risk RSP shines. The ETF’s top 10 holdings combine for 5.1% of its weight. Conversely, a cap-weighted S&P 500 ETF allocates more than 7% of its weight to Apple (NASDAQ: AAPL) alone.
Equal-weight strategies, including RSP, offer another benefit. These funds are designed to not become excessively exposed to a small number of stocks. They also steer investors away from pockets of richly valued names. These days, that’s something to consider.
“Expensive stocks keep getting more expensive,” adds Shalett. “This is a risk because rich price-to-earnings (P/E) valuations are extremely dependent on low interest rates. Which tend to make the projected value of these companies’ future earnings look more attractive to investors. Should the Federal Reserve keep policy rates higher for longer, the index may be more rate-sensitive and subject to greater volatility than many investors assume.”
The Morgan Stanley strategist advocates for small-cap and value stocks going forward. Two styles are frequently mentioned as the driver of equal-weight’s long-term out-performance.
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