A Tale of Two Indexing Approaches: Differences, Uses, and Risks
By TMC Research Staff | The Milwaukee Company | tmcresearch@themilwaukeecompany.com
In the realm of exchange-traded funds (ETFs), the structural design of the funds can significantly influence their performance. The Invesco S&P 500 Equal Weight ETF (RSP) and the SPDR S&P 500 ETF Trust (SPY) offer an excellent case study. Despite both using the S&P 500 as a benchmark and holding the same set of stocks, their performance can diverge sharply due to their weighting methodologies. Here’s an in-depth look at why RSP and SPY have different performance profiles and how they suit different investment objectives, considering the Pareto Principle and market concentration dynamics.
Understanding the Weighting Methodologies
SPY uses a market-capitalization weighting system that mirrors the S&P 500 index, where larger companies tend to have a greater influence on the index's performance. Major tech companies such as Apple, Microsoft, Nvidia, Alphabet, and Amazon comprise a substantial portion of SPY's holdings. Consequently, when these companies perform well, they significantly drive SPY's overall performance.
RSP, on the other hand, employs an equal-weighting strategy. This means that each company in the S&P 500 has an equal share in the index, regardless of its market capitalization. While this arguably provides a more balanced exposure, it also means that the outperformance of a few large-cap stocks will generally have a diluted impact on the ETF’s overall performance. Meanwhile, smaller-cap companies in the S&P 500 will have a relatively higher influence on an equal-weighted portfolio.
The Pareto Principle in Financial Markets
The Pareto Principle, or the 80/20 rule, suggests that 80% of effects come from 20% of causes. This principle, named after Italian economist Vilfredo Pareto, who observed the 80/20 distribution in wealth and land ownership in Italy, has broad applications across various domains, including economics, business, and finance. In financial markets, this often translates to a small number of large-cap stocks driving the majority of market returns. Renowned mathematician Benoit Mandelbrot and other economists have explored its relevance, demonstrating how market performance can often be disproportionately influenced by a handful of stocks.
Market Concentration and Its Implications
In recent years, the S&P 500 has seen increased concentration in a few sectors, particularly technology. As of June 2024, the top 10 stocks in the S&P 500 accounted for approximately 29% of the index’s weight. This includes tech giants like Apple, Alphabet, Nvidia, Microsoft, and Amazon, whose substantial growth has propelled the index to record highs.
Equal-weighted indices like those employed by RSP, however, spread their exposure evenly across all underlying stocks in the S&P 500. This structure inherently reduces the impact of any single stock’s performance on the index. While this can be potentially beneficial in diversifying risk, it also means that RSP may miss out on the outsized gains that can potentially come from the top-performing large-cap stocks.
Valuation Metrics and Overvaluation Concerns
Analysts have noted that SPY has become quite expensive according to traditional valuation metrics such as the price-to-earnings (P/E) ratio, dividend yield, and the price/earnings-to-growth (PEG) ratio. The fund currently trades at a forward P/E of 22.75x, with an expected earnings per share (EPS) growth rate of 16.2%. Its trailing twelve-month (TTM) P/E is even higher, at 28.5x, about 4 percentage points above the long-term average. Additionally, SPY's dividend yield is currently 1.23%, relatively low compared to historical standards, suggesting potential overvaluation.
Despite these concerns, market sentiment indicates that the rally driven by advancements in Artificial Intelligence (AI) is not a fleeting trend like the dot-com boom of the early 2000s. Many believe this could mark a new era of human progress, with AI driving substantial economic growth and innovation.
Comparison with RSP
When comparing RSP and SPY using the same valuation metrics, RSP tends to show different characteristics due to its equal-weighting strategy:
P/E Ratio: RSP’s P/E ratio is 16.14, considerably lower than SPY's, because it is less influenced by high P/E large-cap stocks. This can make RSP appear more reasonably valued.
Dividend Yield: RSP has a slightly higher dividend yield compared to SPY, reflecting its broader exposure to companies that may not be in the top tier of market capitalization but still offer sizeable dividends.
PEG Ratio: Given RSP's broader exposure to a mix of growth and value stocks, its PEG ratio is lower than SPY’s, indicating potentially more balanced growth prospects.
Capturing Market Upswings
Capturing market upswings is crucial, as periods of positive uptrends can account for much of a market's outperformance. Research indicates that during these upswings, large-cap stocks often tend to lead the charge. Their significant weight in market-cap-weighted indices like SPY means that these indices are better positioned to capitalize on such trends. By contrast, the equal weighting of RSP generally dilutes the impact of these top performers, leading to potential underperformance relative to SPY.
Historical analysis lends credence to this observation. During the 2010s, large-cap stocks such as Apple, Amazon, and Microsoft significantly drove market returns. These companies not only led in technological advancements but also in market performance, contributing substantially to the overall gains of the S&P 500 index. For instance, the S&P 500 rallied over 188% during the 2010s, with tech giants like Netflix achieving returns of approximately 4150% over the decade. This tech-driven growth was a major factor in the index's performance. The chart below shows the 15-year growth comparison between SPY and RSP.
Future Potential and Use Cases
Scenario Analysis: Broadcom vs. Nvidia
Consider a hypothetical scenario where Broadcom (an AI centric chipmaker), currently a relatively smaller constituent in the S&P 500, becomes the new AI darling. If Nvidia, a current heavyweight, falls out of favor, the market-cap weighting of SPY would adjust to increase Broadcom's influence as its market cap rises. While the initial impact of Nvidia’s decline on SPY could be larger, over the long term, SPY is generally better positioned to capture the gains from Broadcom's performance. On the other hand, RSP, with its equal weighting, would not see the same level of outperformance driven by Broadcom's gains. This structural difference highlights why SPY can better adapt to shifts in market leadership.
Secular Market Decline
In a secular decline in the stock market, both SPY and RSP would be affected. SPY might experience a larger initial impact due to its higher concentration in large-cap stocks, but this may not be = a sufficient reason to favor RSP. The potential for capturing significant upswings in market trends makes SPY a more compelling choice in many scenarios. Below is the drawdown chart comparing SPY and RSP. The chart shows a mixed performance, with RSP not being particularly effective at avoiding a secular decline.
The Case for RSP
RSP offers equal-weighted exposure to all companies in the S&P 500, ensuring that each stock has an equal influence on the overall performance of the ETF. This structure can be particularly appealing for investors who are wary of the concentration risk associated with market-cap-weighted indices like SPY. By giving equal weight to each stock, RSP reduces the over-reliance on large-cap stocks, potentially offering more stability and diversification.
For investors who prefer a more balanced approach and are willing to sacrifice some potential return for reduced concentration risk, RSP can be an attractive option. It is suitable for those who are comfortable with higher volatility and potentially lower returns, as the equal-weight strategy may not capitalize on the outsized performance of the largest stocks.
The Case for SPY
In contrast, SPY is a market-cap-weighted ETF that reflects the composition of the S&P 500. This structure allows it to benefit from the strong performance of large-cap stocks, which have historically been significant drivers of market returns. The Pareto Principle and market concentration dynamics suggest that a small number of large-cap stocks often generate a substantial portion of the market's gains.
Investors with a higher risk tolerance and a focus on long-term growth may find SPY more suitable due to its ability to capture significant gains from market leaders. The lower expense ratios and the potential for higher returns make SPY an attractive choice for those looking to maximize their investment in a concentrated market environment.
Suitability Based on Use Cases, Risk Profile, and Appetite
SPY:
Use Case: Ideal for investors seeking to capitalize on the performance of large-cap stocks.
Risk Profile: Suitable for those with a higher risk tolerance.
Appetite: Focus on long-term growth and potential to harness significant gains from market leaders.
RSP:
Use Case: Suitable for investors desiring a more balanced exposure across all S&P 500 companies.
Risk Profile: Appropriate for investors seeking to diversify their portfolio risk and who are willing to tolerate periods of higher volatility.
Appetite: Preference for diversified risk and potentially lower returns.
Conclusion
Both RSP and SPY offer distinct advantages depending on an investor's goals and risk tolerance. While RSP provides a more balanced exposure, reducing concentration risk, SPY's market-cap-weighted structure positions it to potentially deliver higher returns by capitalizing on the performance of large-cap stocks.
By understanding these nuances, investors can make more informed decisions about which ETF aligns better with their investment objectives. However, it is essential to consult with your financial advisor before making any investment decisions. This information is intended for general educational purposes only and should not be considered as personalized investment advice. Your financial advisor can provide guidance tailored to your specific financial situation and investment goals.