The S&P 500 Index (SPX) is one of the most popular indexes in the world. It is a market capitalization-weighted index where the individual components are weighted based on their market capitalizations. The larger the market-cap weighting the larger the percentage weighting in the overall index. For instance, the trillion-plus market-cap companies such as MSFT, AAPL, AMZN, and GOOGL/GOOG make up a bigger percentage of the overall index, and as such will exert a greater influence on the overall direction of the underlying index (SPX), both to the upside and to the downside.
The opposite of the S&P 500 market-cap weighted index is the less popular S&P 500 equal-weighted ETF (RSP). Instead of being market-cap-weighted, these indexes are equal-weighted in terms of the allocation. That is each of the 500 stocks in RSP may have 0.2% allocation and each is equally distributed within the index. This allows the buyer of RSP to have the same exposure to all the SPX names without favoring either the larger-cap or smaller-cap weighted names.
To equal weight (SPY) or not to equal weight (RSP) - That is the question.
There have been numerous studies over the years that try to address the above question. It appears that there is some evidence to suggest equal-weighted indexes may offer slightly higher returns than the more popular market-cap-weighted indexes over the long-run. We suspect the primary reasons for this outperformance cycle over the long run are because equal-weighted indexes invest an equal amount in all the stocks in the index, and hence this will lead to constantly rebalancing of the index. This is a subtle form of constant diversification or applying smart beta strategies to a portfolio by capturing investment factors or market inefficiencies in a transparent way. Another simple explanation for its superior outperformance centers upon the longer-term historical outperformance from the smaller cap stocks as compared to larger-cap stocks in the index.
We will let the academics and the quants debate the value of investing in market-cap-weighted indexes or equal-weighted indexes. From a technical perspective, it is our contention sustainable market rallies especially longer-term bull trends depend heavily on the confirmation between the market-cap-weighted indexes and their equal-weighted counterparts. In other words, ideally, we would like to see a breakout to new all-time highs in the market-cap weighted index followed by new record highs in the equal-weighted index and vice versa. Positive divergences as well as negative divergences between the two indexes often signal the potential for trend changes in the indexes in question.
Enclosed below is a technical review of the equal-weighted ETF (RSP). Also, attached are charts of the respective 11 market-cap-weighted S&P 500 sectors and the 11 equal-weighted S&P 500 sectors.