The research-backed alternative for allocating your investments

Whether you use indices or select your own investments, chances are some of the largest holdings you have are dedicated to some of the biggest companies. On the surface of it all, this might seem to make sense. 

The biggest companies by market capitalisation should, in theory, be able to offer more consistent and larger returns for you and allow you to participate more fully in market returns… but do they? 

The top 10 companies by market capitalisation of the S&P/ASX 200 account for nearly half of the index, while the top 10 companies in the S&P 500 account for 34% of the index. 

But at the end of the day, market capitalisation will tell you more about the index's past rather than a company’s fundamentals or its future.

But if a market-weighted approach is not the way to go, what is the correct way to weight your portfolio, particularly if you are a passive investor? The research suggests equal weighting offers a suitable market alternative for greater diversification and to reduce your concentration risks.

In this wire, I’ll take a closer look with the help of VanEck’s CEO and Managing Director, Asia Pacific, Arian Neiron.

What is equal weighting compared to market-cap weighting?

A market-cap weighting is where the weighting of each company in an index is based on its market capitalisation, from largest to smallest. Most stock market indices, such as the S&P/ASX 200, the S&P 500 or the Nasdaq 100 are constructed this way.

By contrast, an equal-weighted index is agnostic to market capitalisation.

“Taking an equal weighting approach simply means each company is given the same weight in the portfolio, rather than allocating according to company size. This results in a portfolio that cannot be dominated by any company or sector, reducing the concentration risk that characterises the S&P/ASX 200,” says Neiron.

Following the data: research favours equal-weighting

"The current use of market capitalisation indices as the basis for investing, like the S&P/ASX 200, is a bit of an accident of history,” says Neiron.

He explains the approach was pioneered in the 1920s with the simple intent to act as a barometer of health for the stock market.

“Investing has become much more sophisticated since then with decades of academia, established modern finance principles, and experienced and developed industry and technological evolutions,” he says.

Neiron points to a range of research on the market cap indices.

One example was a paper compiled by S&P Global in 2018 which found outperformance in equal-weighted strategies compared to market capitalisation-weighted counterparts because smaller companies have tended to outperform larger companies in bull markets along with using equal-weighting within sectors.

It also noted that rebalancing can add a contrarian component to equal-weight strategies. The paper also highlighted a meaningful bias towards value and higher dividends in equal-weighted strategies.

Australia’s CSIRO-Monash Superannuation Cluster found that equal weighting strategies have historically outperformed over the long term due to three factors.

1. Higher exposure to smaller stocks rather than larger ones.
2. Higher exposure to value stocks – that is, stocks with a high book-to-market ratio
3. Market timing – extracts more returns when markets are rising and loses less when markets are falling.

The idea of contrarian investing is also significant to the long-term performance of equal-weighted indices.

“In an equal-weighted portfolio, contrarian trading is when, at rebalance, an equally weighted portfolio buys more of the stocks that have fallen since the last rebalance and locks in gains by selling those that have gained the most since the last rebalance,” Neiron says.

Other bodies of research have explored the efficacy of market-cap-weighted indices.

“The findings surmise that stock prices do not always reflect a company’s fundamentals, and a market cap strategy can be underweight stocks which are undervalued, and overweight stocks which are overvalued,” says Neiron.

In the case of VanEck's own equal-weighted offering, the VanEck Australia Equal Weight ETF (ASX: MVW) has returned 9.31% pa since inception 10 years ago, and outperformed the S&P/ASX 200 by 1.05% pa. 

Portfolios are generally built with different investment management styles and outcomes in mind. Each strategy can be employed by investors to improve on risk-adjusted returns.

The concentration risk in markets

It’s hardly a secret that markets are highly concentrated. In the case of Australia, bankers and miners dominate the top 10 of the S&P/ASX 200.

Neiron argues that prudent fund management should focus on risk management as part of the pursuit of returns.

“A portfolio that allocates 45% to just 10 companies, which is the case for a fund tracking the S&P/ASX 200, is arguably not prudent,” he says.

He gives the example of using the Herfindahl Index to compare the S&P/ASX 200 with an equal-weighted version, the VanEck Australian Equal Weight ETF (ASX: MVW). The result was that the equal-weighted option was 2.5x more diversified than the market-cap weighted index.

It’s something to consider in a market where bank valuations are stretched but in the top allocations of the market-weighted indices. Take Commonwealth Bank (ASX: CBA) which is the most expensive bank at the moment, trading on 23x earnings.

“At some point in time, Commonwealth Bank’s valuation will revert to a level which is more reflective of its peers, or not. Although it is a phenomenal enterprise, at these prices, it may not be prudent to allocate 10% of a portfolio which is the current weighting in the S&P/ASX 200,” says Neiron.

Reporting season further highlights the value of balance

Reporting season can be an unpredictable time in markets – and the latest one was no exception.

“Being overweight banks and resources means your portfolio is driven by cyclical stocks, and demand for Australia’s mined resources has been waning as China reorientates its economy and concerns around global growth,” says Neiron.

Mid-cap stocks have outperformed larger caps in the latest round of results – an outcome in which those investing in an equal-weighted style may have seen more of the benefit compared to those in market-cap weightings. As Neiron says, mid-caps often have more growth potential than larger companies too.

Final thoughts

“Remember, in the quest for wealth, balance is key – not just in terms of spreading risk but spreading across opportunities,” says Neiron.

“It’s about giving every idea room to grow. An equal-weight portfolio is like a democracy where every stock has the opportunity, no one is ordained as king to reign supreme in perpetuity. The biggest isn’t always the best.”

Find out more about VanEck’s award-winning Australian equal weight ETF (ASX: MVW) here. 

*Please note this wire was updated to reference MVW's performance compared to the index at 3.45pm, Wednesday 4 September 2024.