What Most Market Indexers Get Completely Wrong

(For example, giants like Nvidia and Microsoft represent just 0.2% apiece in this portfolio versus several percent in a traditional S&P 500 index fund.)

Reduced concentration lessens the risk tied to sector bubbles or individual high-flyers.

Quarterly rebalancing adds a “buy low, sell high” dynamic, increasing exposure to laggards and trimming outperformers.

Equal-weight indexes provide higher yields, offering more income for investors.

They also offer greater participation from small and mid-sized firms, which – believe it or not – have historically provided superior returns to large caps. Just not lately.

What are the drawbacks?

Well, you can guess the first: potential underperformance during mega cap tech rallies.

Small- and mid-sized stocks can also be more volatile, making the funds themselves a bit more volatile.

There is also higher turnover – and thus higher costs. The fund above has an average expense ratio of 0.2%.

That’s tiny but still twice the expense ratio of the SPDR S&P 500 Trust (NYSE: SPY).

Plus, the quarterly rebalancing in an equal-weight fund has tax ramifications.

Whereas most index funds are highly tax efficient, these funds occasionally distribute realized capital gains after top performers are trimmed back.

That’s why equal-weight funds are ideally owned in a qualified retirement plan where they will compound tax-deferred.

However, die-hard indexers often say there is a single overriding reason they prefer the market cap weighted approach to an equal-weighted one.

Higher returns.

No one can argue that equal-weighted index funds have outperformed market-weighted ones over the past few years. They haven’t.

However, they certainly have over the long haul.

Over the past 25 years, in fact, MSCI’s U.S. equal-weight index has outperformed its size-weighted counterpart by an average of 1.2 percentage points a year.

Some readers may think that’s not a big deal. But it is.

An investor in an equal-weight fund would be one-third richer at the end of the period.

In other words, if your investment in a traditional S&P 500 over the past 25 years grew to $1 million, congratulations!

Yet it takes some of the shine off to learn that the same investment in an equal-weighted index over the same period would have grown to more than $1.3 million.

(Or that $10 million would have turned into over $13 million.)

The second approach required no additional time. No additional work. Just a tiny tweak that made a difference of hundreds of thousands – or millions – of dollars.

So these are the considerable advantages: less concentration risk, more income, and vastly higher long-term performance.

If you have fresh money to put to work today – especially if it’s in a retirement account – it should go into an equal-weight index not a market cap weighted index.

And that’s especially true with mega cap tech valuations where they are today.

Good investing,

Alex

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