Recently, I’ve been alarmed with the amount of influence a small number of companies have on the overall performance of the S&P 500. For most folks, a set it and forget it approach with the market weight S&P 500 is the best course of action. But at the time of this writing, the 5 largest companies in the S&P 500 make up 25% of the index. If you are concerned about taking on too much company specific risk in what should be a broad market basket of the US economy, consider investing in an equal weight ETF.
What is an Equal Weight ETF?
When you own popular S&P 500 ETFs (SPY, VOO, IVV), your investment is not evenly distributed across the 500 companies. It is allocated across the investments by the market capitalization of each company. An Equal Weight ETF distributes the weight of each investment evenly across all the holdings within the portfolio.
Overvaluation Risk
As a stock’s value surges, your exposure to it within the market weight ETF increases. This is a double edged sword. On one hand, you are getting increasing exposure to potential winners. On the other, you could be inflating your exposure to a potentially overvalued company.
Take Tesla (TSLA) for example. Tesla’s stock has been especially volatile, experiencing remarkable surges in market value that may not always align with its underlying fundamentals. At the time of this writing, TSLA makes up 1.4% of the S&P 500. Each time Elon is accused of taking mushrooms, or smoking a blunt on The Joe Rogan Experience, this sizably affects your market weight S&P 500 ETF.
The overvaluation risk is especially important in times of irrational exuberance. During bubbles, stocks trade at prices that are disconnected from their underlying fundamentals. As they become increasingly disconnected, your exposure to them rises proportionally.
Creating a More Balanced Portfolio
The goal of the equal weight ETF is to create a more balanced portfolio that helps reduce single stock specific risk. If Microsoft were to go bankrupt, a share of the SPY would be worth 7% less. Compare this to an equal weight S&P 500 ETF, like RSP, which would lose 0.2% of its value.
Allocating some of your money into an equal weight S&P 500 ETF will help reduce concentration risk. People tend to think of the S&P 500 as a basket of stocks that closely mimic the behavior of the US economy. But did you know that tech makes up 30% of the index? An equal weight market index gives an added layer of sector neutrality, since it rebalances its holdings.
Past Performance Is Not Indicative of Future Results, But We Can Learn From History
Creative destruction fuels economic prosperity. It’s not a coincidence that only 52 companies have been on the Fortune 500 list since 1955. Capitalism is vicious and productive. I won’t bother predicting which company will be the next big thing. A forecast tells you more about the forecaster than it does about the future.
What I can promise you is that there will be a company that does not exist today that will change the world. And that company will probably do so at the expense of one of America’s largest corporations today. If you believe in buying and holding for the long run, why take on the additional stock specific risk?
