THE RATIONAL INVESTOR: For index fund investors, it's not so simple anymore

Robert Stepleman

Many investors prefer to invest in index mutual funds and exchange-traded funds. I support this with two caveats: First, the investor should understand the details of how the fund is constructed. Second, investors with large dollar portfolios should understand the pros and cons versus investing in individual securities.

One reason investors choose index funds is because it’s looks “uncomplicated.” Unfortunately, over the last couple of decades, it has become more complicated because index funds that track the same index can do it in diverse ways.

That’s because there are many ways to decide the weight of each stock in an index. Just to name a few examples: They can be capitalization-weighted, price-weighted, equal-weighted, or dividend-weighted. This doesn’t change the stocks in the index, just the proportion of each one in the index.

To better understand the possible impact of this, let’s look at two weightings for the S&P 500. Historically, it has been capitalization-weighted; that is, the proportion of each of the stocks in the index was determined by its market capitalization. Recall, this is market price multiplied by the number of shares outstanding. This means the index’s performance could be dominated by just the largest capitalization stocks, with the rest of the index’s components having negligible impact.

To counter this, it was proposed each stock in the S&P 500 should be equal-weighted; that means they would all have the same impact on index performance. This gave rise to the S&P 500 equal-weighted index. Those supporting it posited that this index would be a better measure of the market’s performance and could outperform the capitalization-weighted incarnation. That’s because there’s evidence smaller capitalization stocks outperform larger capitalization stocks over time and rebalancing the index more frequently; that is, selling some shares of the stocks that did well and buying some shares that did poorly would also increase performance.

How has this “competition” worked out?

Historically, equal-weight indexing has provided outperformance during periods of recovery. For example, from the market low of March 9, 2009, over the next year the market-capitalization S&P 500 gained 72% while the equal-weight version gained 107%. Similarly, over the year after the dotcom crash bottom on Oct. 9, 2002, the capitalization-weighted version gained 36%, while the equal-weighted version gained 59%. From 2003 through 2021, its annualized return has been 1.17 percentage points higher. More recently for 2021, it outperformed by .92 percentage points.

Let’s understand some of the differences besides performance. The equal-weight version is more diversified since the cap-weighted version’s performance is largely determined by just the top 5-10 stocks. Technically, this means the cap-weighted is driven by momentum because the weight of the stock increases as its price increases, giving it more impact on the index. The equal-weight version will have higher turnover which will result in higher costs. It also can be more volatile due to the heavier impact of small-cap stocks.

In summary: Carefully choose not only the index you want to invest in but also the way the index fund that tracks that index is constructed.

All data and forecasts are for illustrative purposes only and not an inducement to buy or sell any security. Past performance is not indicative of future results. If you have a financial issue that you would like to see discussed in this column or have other comments or questions, Robert Stepleman can be reached c/o Dow Wealth Management, 8205 Nature’s Way, Lakewood Ranch, FL 34202 or at He offers advisory services through Bolton Global Asset Management, an SEC-registered investment adviser and is associated Dow Wealth Management, LLC.

This article originally appeared on Sarasota Herald-Tribune: ROBERT STEPLEMAN: For index fund investors, it’s not so simple anymore

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