There has been a lot of talk recently about ETF investing and how flawed some of the strategies can be, so I decided to do some digging to see if this was true or not. The most common complaint I hear is that many S&P 500 ETFs are overweight compared to an equal-weight S&P 500 ETF, but is this a bad thing?
Let’s start with an explanation of the differences between the two ETFs. You’ve probably heard of some of the most popular S&P 500 ETFs, such as SPY, my personal favorite. That ETF holds all 500 S&P 500 companies, but it is weighted by market capitalization. That means the largest companies will have a greater impact on the ETF’s share price, which can be beneficial but can also be detrimental.
As you can see, there are only five major companies (AAPL, AMZN, GOOG, MSFT, and FB) that account for roughly half of the market capitalization of the S&P 500 ETF. These five companies add up to 50 times what they would if they were equally weighted. Those 5 companies only account for about 22% of SPY, my favorite S&P 500 ETF, as of September 2021, but that’s still a lot!
Which brings us to the next option: an S&P 500 ETF with equal weighting. An equal-weight S&P 500 ETF is exactly that: it has the same weight as the S&P 500 index. Every company is given the same weighting, regardless of its market capitalization.
As I previously stated, the question is whether or not this is a good thing. In the end, it comes down to two opposing viewpoints:
1 — You think it’s a bad thing because your investment isn’t very diversified, with 5 companies accounting for 22% of the total.
2 — You think that it is a good thing because theoretically, the larger that the company is, the better they are
Honestly, I flip back and forth on my opinion of these two viewpoints and can legitimately see it both ways.
If you’re not in favor of the ETF because you’re not diversified, I can’t disagree at all with that because you’re really not. A large majority of the companies that you’re investing in are making up a much, much smaller amount than those Top 5 companies are.
Another issue with this is that if you look at those five companies that make up the 22 percent — what do they all have in common?
They’re all tech companies! Personally, I love tech companies and think that they’re the way of the future, but I understand why you wouldn’t want HALF of your investment to be in tech if this was where you were parking all of your money for the long-term.
If you are in favor, I think that makes sense too — big companies have grown because they have shown long periods of sustained success. If you’re investing in an S&P 500, that’s what you’re looking for — somewhere that you can dump your money and not have to worry about it again until you decide to take it out for retirement.
Personally, I would want a majority of my money to be invested in companies that are continuing to crush it rather than those that are company 499 in the S&P 500.
All of these are merely just qualitative factors though. If you know anything about you me, I am a man that lives and dies by the numbers, so let’s dive deep!
For this comparison, I am going to compare two different ETFs:
SPY is an S&P 500 ETF that is weighted by market cap
RSP is an equal weight S&P 500 ETF
Before you go any further, I challenge you to take a step back and think about what you think the outcome is going to be. I think that taking some time to think about the answer beforehand, and then wiping your memory completely clean and going into the analysis with an open mind is key.
Something that I have an issue with is confirmation bias, where I’m essentially looking for data to support the conclusion that I want to find. I have found that taking the time to think about any preconceived notions and then making the conscious effort to ignore them will make you a better investor.
Personally, I think SPY is going to crush RSP. I would want my money to be invested in the companies that have grown the most because hopefully, that means they’re poised to continue their dominance.
I went back to 1/1/2004 as RSP started mid-year 2003 to keep the data clean. Below is an annual breakdown of the ETF returns for RSP and SPY, as well as a comparison between the two ETFs:
The chart shows a lot of data, but the thing that I immediately get sucked into is the Total Return. The total for RSP is 366 percent while SPY is nearly 351 percent , so you’re talking just about a 15 percent improvement over SPY over the long-term.
Now, another thing that immediately sticks out to me is that a very large majority of that occurred in 2009 when SPY was nearly 20 percent worse than RSP. Based on the next largest variance being in 2019 when RSP was 6.27 percent worse than SPY, I would venture to guess that might be an outlier.
Now you can never throw out data because it is real data that actually occurred, but it’s important to think about if it’s repeatable or not. Below I breakdown the average and median annual returns for both ETFs — one dataset includes all years and the other excludes 2009:
Clearly a pretty big shakeup between RSP and SPY when you exclude 2009. The average outperformance for RSP goes from .84 percent to be a .35 percent underperformer.
Personally, if I were making an investment decision, I would probably rule out 2009 because the 20 percent variance doesn’t seem repeatable, especially since the next closest year had a variance of only 1/3 of that at 6.27 percent, but that’s just me.
So, my opinion would be that so far, these ETFs are actually pretty equal. That means you can put your money into either one, right?
Well, maybe — but you’re forgetting something…DIVIDENDS!
Dividends play a huge factor when you’re investing so it’s imperative that you take that into account. I have talked before about the importance of looking at the Total Yield, which is the annual return + dividend yield because if not, you’re comparing apples to oranges from the get-go.
Below shows the dividend paid each year for the respective ETF as well as the dividend growth:
The RSP dividend growth absolutely puts the SPY dividend growth to shame! I am pretty surprised by this because typically when you think of older, well-established companies, which typically would make up more of SPY because they have a higher market cap, I would think that they would pay larger dividends.
The more that I thought about it, though, the more it made sense. FB, AMZN and GOOG all do not pay dividends currently, so about 30 percent of SPY isn’t paying a dividend while those three companies would all be equally weighted with RSP, therefore not dragging down the total dividend nearly as much.
However, AAPL does pay an incredible dividend so hopefully they can try to make up a little bit for the other three laggards!
Similar to how I threw out an outlier in the share price return section, I want to see if there are any major outliers in this dividend growth section as well.
I instantly see that in 2017 there was a 43 percent outperformance of RSP vs SPY, and that seems a little bit high! Looking at some of the other years, there were some pretty major discrepancies such as when RSP underperformed by 28 percent in 2016 and outperformed by 19 percent in 2020, but neither of those are close to that 43 percent level.
Ok, back to the outlier conversation — you can see that the average RSP growth rate is nearly 6 percent more than SPY and the median is nearly 9 percent ! Even if I take out the massive outperformance in 2017, RSP is still crushing SPY:
Now, it’s always important to remember that everything that I have shown so far is simply just the past and not an indication of how these ETFs are going to perform in the future, but that’s really all that we have to go on when we’re evaluating ETFs.
One of my favorite things to do as a “last check” when I am investing is to go back and look at the history of how my real, hard-earned money would’ve actually performed if I had invested it in this way. To do this, I go to a DRIP Return Calculator from the Dividend Channel (https://www.dividendchannel.com/drip-returns-calculator/)
It’s really interesting because you can enter the pertinent info and pick a specific date and then see how actual returns would’ve looked for you. I entered in the information for RSP and then started it on 1/1/2004 and compared it to SPY, as you can see below:
How do you think the results turned out? Probably a slight advantage for RSP right? That’s what I am thinking!
According to the data, $10K would have turned into $51,593.89 with RSP and $46,173.64 with SPY. Might not seem like a crazy amount being about $5800, but it actually is a huge difference.
After deducting your $10,000 investment, you’ve made $41,954 with RSP. That’s nearly a 16 percent increase over what you’d have made with SPY. Sure, it’s only $5800 in this case, but it’s $58K if you had invested $100,000. A $500K investment would result in a $290K increase. You can see how quickly it adds up.
And these are the returns if you didn’t reinvest your dividends back into the ETF, which I always recommend doing as long as you like the stock. Wonder why I advise that? I’ll show you:
Simply by putting those dividends to work you now have amounts that are about $8K more regardless of the ETF that you had chosen to invest in. Putting your money to work as soon as you can is mathematically proven to work better than holding onto the cash and trying to time the market, and that’s why I also recommend lump sum investing instead of dollar cost averaging.
What this tells me is that the performance of SPY must have grown faster later on, and when we look at the data, we do see that SPY actually outperformed RSP on 6 of the last 7 years.
Summary
As it turns out, investing in an equal weight S&P 500 ETF mathematically has shown to be more prosperous than investing in a market cap weighted S&P 500 ETF like SPY. As I mentioned, this is not at all what I was expecting the data to show me, and this is why you should always go into analysis with an open mind. What do you think?
Enjoy learning stuff like this? Click here to subscribe.
I recommend M1 Finance for long-term investing– Click Here to sign up with a special offer.
Data and image source: https://einvestingforbeginners.com/equal-weight-sp-500-etf-ansh/
