These 2 ETFs show why owning small-cap stocks is key to beating the market at times like this

Small has been good this year on Wall Street. This is because small-cap stocks within the S&P 500 SPX,
they have far outperformed the largest caps since January. The eight stocks with the largest market capitalizations at the start of the year, which at the time accounted for the maximum 27.2% of the total market capitalization of the entire index, have lost an average of 40.4% so far this year. year (through Nov. 21), according to FactSet. That’s more than three times the average 9.5% loss among the remaining more than 490 stocks in the S&P 500.

Meta META Platforms,
it’s the biggest loser year-to-date, down 67.3%, but it’s certainly not the only stock to drop the average. NVIDIA NVDA,
the 8th the largest stock in the S&P 500 as of early 2022, was down 47.9% through the end of October, and Amazon AMZN,
the third largest, fell 44.5%. The chart below shows how the eight largest-cap stocks in the S&P 500 lost more than average at the start of the year.

This stark contrast explains why the equally weighted version of the S&P 500 index outperformed the traditional, capitalization-weighted version, the version you see reported every day in the financial press. The equal weighting strategy assigns each of the index component stocks an equal weight in the index, while the capitalization-weighted approach ranks each stock according to its market value. Given that stocks representing more than a quarter of the S&P 500 index have lost more than three times the average across all other components, it is not surprising that the year-to-date return of the cap-weighted S&P 500 is much lower than the equivalent version by weight — by 6.0 percentage points.

That’s the largest alpha for the peer-weight version in more than a decade, assuming this 6.0 percentage point differential holds through the end of the year. You have to go back to 2010 to find another calendar year where equal-weight alpha was greater. At that time the alpha was 6.3 percentage points.

Of course, the weighted version of the index does not always outperform the cap-weighted version. Long-term data paints a picture of the two versions virtually breaking even. Since 1971, when S&P Global calculated the performance of the weight-for-weight version, the weight-for-weight version has produced a dividend-adjusted yield of 12.2% annualized, as opposed to the 10.8% for the weight-adjusted version. weighted by capitalization. But the higher yielding version of equal weight was produced with 13% more volatility, which is a measure of risk. On a risk-adjusted basis, the two are nearly neck and neck, with equal weight slightly ahead.

This slight advantage largely disappears when transaction costs and management fees are taken into account. Transaction costs are higher for the equal-weighted version because, by default, it has to undergo more periodic rebalancing transactions than the cap-weighted version. The annual turnover ratio for SPDR S&P 500 ETF Trust SPY,
is 2%, for example, in contrast to 38% for Invesco S&P 500 Equal Weight ETF RSP,
Management fees are also higher for the Invesco ETF (0.20% pa of assets under management) than for the SPDR product (0.0945% of AUM).

The Invesco ETF has only been around since 2003, so we only have two decades of real-world experience for the two weighting schemes. The peer-weight ETF has since narrowly outperformed the SPDR ETF on a raw, unadjusted basis, but lagged on a risk-adjusted basis.

What to expect

Lawrence Tint, the former US CEO of Barclays Global Investors, the organization that created iShares (now part of Blackrock), thinks it’s a question which weighting scheme will do best over the next few decades. In an interview, Tint said there will be times when larger-cap stocks suffer disproportionately, such as this year, and when that happens, the cap-weighted version will lag the equal-weighted version. . But, Tint added, there will be other times where it will be quite the opposite.

Tint said he doesn’t know of any theoretical reason why relative advantage should always go one way or the other.

Tint’s argument gets historical support from the chart above, which plots the difference in trailing 10-year annualized returns of the peer-weight and cap-weight version of the S&P 500. This difference fluctuated between periods of peer-weight outperformance and underperformance. Please note that these returns are calculated on the basis of the theoretical returns of the indices themselves and do not take into account transaction costs and management fees. Adjusted for costs and fees, the data series in the chart would shift down.

One approach you might take to decide between the cap and equal-weighted versions of the S&P 500 is your tolerance for volatility-related risk. Because the equal-weighted version has historically been 13% more volatile than the cap-weighted version, you could think of it as the functional equivalent of buying the cap-weighted version with a 13% margin.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Rating tracks investment newsletters that pay a flat fee to be audited. It can be reached at

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