These 2 ETFs show why owning small-cap stocks is key to beating the market in times like these

These 2 ETFs show why owning small-cap stocks is key to beating the market in times like these

Small has been fine this year on Wall Street. This is because the smaller cap stocks of the S&P 500 SPX,
have largely outperformed larger cap stocks since January. The eight stocks with the largest market capitalizations at the start of the year – which at the time represented 27.2% of the total market capitalization of the entire index – lost an average of 40.4% until now this year (through Nov. 21), according to FactSet. That’s more than three times the 9.5% average loss among the more than 490 remaining stocks in the S&P 500.

Meta Platforms META,
is the biggest loser so far this year, down 67.3%, but it’s certainly not the only stock to pull the average down. NVIDIAVDA,
The 8the the largest stock in the S&P 500 at the start of 2022, was down 47.9% through the end of October, and Amazon AMZN,
the third largest, was down 44.5%. The chart below shows how the eight largest stocks in the S&P 500 at the start of the year lost more than average.

This stark contrast explains why the equal-weighted version of the S&P 500 index has outperformed the traditional capitalization-weighted version – the version you see reported every day in the financial press. The equal weighting strategy gives each of the stocks comprising the index the same weight in the index, while the capitalization-weighted approach ranks each stock according to its market value. Given that stocks representing more than a quarter of the S&P 500 index lost more than three times the average of all other components, it is not surprising that the cumulative return of the capitalization-weighted S&P 500 far behind the equal-weighted version – by 6.0 percentage points.

That’s the biggest alpha for the even-weighted version in over a decade, assuming that 6.0 percentage point gap holds through the end of the year. You have to go back to 2010 to find another calendar year in which equal-weighted alpha was greater. At that time, the alpha was 6.3 percentage points.

Of course, the equal-weighted version of the index does not always outperform the market-cap-weighted version. Long-term data paints a picture of both versions in a virtual link. Since 1971, when S&P Global calculated the performance of the equal-weighted version, the equal-weighted version has produced a dividend-adjusted return of 12.2% annualized, compared to 10.8% for the weighted version. based on capitalization. But the higher return of the equal-weighted version was produced with 13% more volatility, which is a measure of risk. On a risk-adjusted basis, the two are almost neck and neck, with equal weight slightly ahead.

This slight advantage largely disappears once transaction costs and management fees are taken into account. Transaction costs are higher for the equal-weighted version because, by design, it has to undergo more periodic rebalancing transactions than the capitalization-weighted version. The annual turnover rate for the SPDR S&P 500 ETF Trust SPY,
is for example 2%, compared to 38% for the Invesco S&P 500 Equal Weight ETF RSP,
Management fees are also higher for the Invesco ETF (0.20% pa of assets under management) than for the SPDR product (0.0945% of AUM).

The Invesco ETF has only been around since 2003, so we only have two decades of real-world experience with both weighting schemes. Since then, the equal-weighted ETF has slightly beaten the SPDR ETF on a raw, unadjusted basis, but lagged on a risk-adjusted basis.

What to expect

Lawrence Tint, the former US CEO of Barclays Global Investors, the organization that created iShares (now part of Blackrock), thinks it’s a toss-up whose weighting system will do better in the decades to come. In an interview, Tint said there will be times when larger-cap stocks will suffer disproportionately, like this year, and when that happens, the cap-weighted version will lag behind the equal-weighted version. But, Tint added, there will be other times when it’s just the opposite.

Tint said he was unaware of any theoretical reason why relative advantage should always go one way or the other.

Tint’s argument receives historical support from the chart above, which plots the difference in 10-year annualized returns of the equal- and maximum-weighted version of the S&P 500. This difference has oscillated between periods of outperformance and equally weighted underperformance. Please note that these returns are calculated on the basis of the theoretical returns of the indices themselves and do not take into account transaction costs and management fees. On an after-cost and after-fee basis, the data series in the chart would move down.

One approach you might take when choosing between the capped and equally weighted versions of the S&P 500 is your volatility risk tolerance. Since the equally-weighted version has always been 13% more volatile than the cap-weighted version, you can think of it as the functional equivalent of buying the cap-weighted version with a margin of 13 %.

Mark Hulbert is a regular MarketWatch contributor. His Hulbert Ratings tracks investment newsletters that pay a fixed fee to be audited. He can be reached at

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