While we are reminded regularly of the need to diversify our investments and not have too much exposure to one area (say the US) or one sector (say technology), most people are quite happy to buy an index ‘tracker’ fund without a second thought to how they are constructed or whether they might also hold hidden risks.

As Shares explains, buying an equal-weighted version of an index fund is an effective way to avoid concentration risk, while a fundamentally based index can help reduce individual stock risk.

THE PROS AND CONS OF INDEX FUNDS

Index funds are a great low-cost way for retail investors to get exposure to a whole market without the aggravation of holding lots of different stocks, which explains why they are such a hit.

As we revealed in a recent article, eight of the 10 most popular funds bought by DIY investors this year have been index trackers, whereas last year that figure was one in 10, which is quite a remarkable turnaround.

When markets are doing well, as they were in the decade prior to 2022, index funds tend to beat active managers, especially if large-cap stocks are driving the market higher because cap-weighted index funds automatically have a high weight in them, which increases with each move up.

In contrast, few active managers have the same weighting in stocks as the index – after all, their ‘edge’ is meant to be their ability to pick stocks themselves – so when a small group of index constituents keeps going up, as the FAANGS did for example, active managers can underperform quite badly.

While it may be an extreme example, in August 2020 just five tech companies accounted for a quarter of the value of the S&P 500, the highest level of concentration since at least 1980 according to analysts at US bank Goldman Sachs (GS:NYSE).

Very few active managers whose funds were open to retail investors could have had the same level of concentration, especially in one sector.

However, when tech stocks took a bashing last year, that under-exposure became a tailwind for active managers and most were able to beat the index.

As a rule, index funds beat stock pickers when prices are going up but tend to underperform active managers when prices are going down.

Another, related issue for index trackers is, like the indices they follow, they tend to buy high and sell low.

When a new stock is added to an index, it is usually because it has performed well and been promoted so the index fund is typically buying it at a premium valuation.

When stocks are dropped from the index, on the other hand, it is usually because they have performed poorly so the tracker fund is forced to sell at a low valuation.

Also, to actively track their benchmarks, index funds are 100% fully invested.

In contrast, active managers typically hold a small percentage of their assets in cash so they can buy when prices fall, meaning a drop in the market is never fully reflected in the fund’s value.

Still, while indexing may not be a perfect solution and index funds may not always win, because stocks more widely tend to go up more often than they go down they have better odds than most active managers.

WHAT OTHER APPROACHES TO INDEXING ARE THERE?

Most major benchmarks bar the Dow Jones Industrial Index are constructed using a free float-adjusted market capitalisation which means you end up owning more of the larger stocks because they have a greater weight in the index.

One obvious alternative to this method is to equal-weight each stock in the index, so in the UK for example an equal-weighted FTSE 100 index would invest the same weight in stocks like Taylor Wimpey (TW.) and Persimmon (PSN), which are at the bottom of the cap-weighted index, as it would AstraZeneca (AZN) and Shell (SHEL), currently the two biggest stocks in the index.

Joachim Klement, head of strategy at research firm Liberum, has long been a believer in the advantages of equal-weighted indices and portfolios.

‘I have argued for more than 15 years, once you take uncertainty about future returns of assets into account, an equal-weighted portfolio is almost impossible to beat overall.

‘The reason why equal-weighted portfolios work, in my view, has to do with our inability to forecast future returns with any reasonable degree of certainty.’

For an equal-weight strategy to work it must be rebalanced from time to time, usually on a quarterly basis, which means you are regularly taking profits on your winners and reinvesting in your losers which is the opposite of what happens with a cap-weighted index.

Also, you are increasing your exposure to two factors – smaller companies and value – which have historically outperformed bigger-cap and more expensive stocks, especially at turning points in the market, while drastically reducing your exposure to the momentum factor.

In the US, 2022 was the best year since 2010 for the equal-weighted S&P 500 index because a large number of smaller stocks did better than the biggest, most popular shares.

In a research paper published last November, Alexander Swade and colleagues from Lancaster University Management School looked at the reasons why the equal-weighted S&P 500 beat the cap-weighted version over several decades.

They found that as well as the small-cap and value effect, there was a significant benefit from taking profits on winners and topping up losers as well as from higher overall profitability across the portfolio and, surprisingly, the ‘January effect’ (the tendency for US stocks to rise in the first month of the year following a year-end sell-off for tax purposes).

However, the effects of some of these factors were less obvious or even became slightly negative in the low interest rate environment ushered in by the financial crisis of 2007 to 2009.

CAN YOU IMPROVE ON A CAP-WEIGHTED INDEX?

Rob Arnott, partner and chair of US firm Research Associates, believes traditional cap-weighted indices can be improved by using a company’s fundamentals to adjust each stock’s weighting, which in turn means fewer deletions and new additions.

‘Additions are usually growth stocks, trading at premium multiples and with impressive momentum, whereas most deletions have the opposite characteristics’, says Arnott.

‘Buying mainly frothy stocks with strong momentum and selling mainly tumbling stocks that are severely out of favour, creates an unhelpful buy-high and sell-low dynamic.’

Choosing stocks based on the size of their underlying business instead would exclude small companies trading on unrealistic future growth expectations and include those with a large economic footprint which are under-priced.

You end up with an index which is 90% the same as the original cap-weighted version but with a higher quality of earnings which translates into better returns.

Between July 1991 and December 2022, the regular cap-weighted S&P 500 generated an average annual return of 9.9% with average volatility of 14.86%, while Arnott’s custom index produced a 10.35% average annual return with lower volatility.

In times of medium and high market volatility such as the bursting of the tech bubble between 1999 and 2002, the global financial crisis of 2007 to 2009 and the recent pandemic, the custom index produced between 70 basis points (0.7%) and 220 basis points (2.2%) of extra annual return with no increase in volatility.

In fact, the tech bubble is a perfect example of an index adding frothy stocks just as they were about crash and argues strongly against including new names based solely on their most recent market cap.

HOW YOU CAN GET EQUAL-WEIGHT EXPOSURE?

While products offering equal-weight exposure to the FTSE 100 and other UK indices are thin on the ground, there are several products which track an equal-weighted S&P 500 index.

Two of the most popular exchange-traded funds in this category are iShares S&P 500 Equal Weight (EWSP) and Xtrackers S&P 500 Equal Weight (XDWE), both of which have an ongoing charge of 0.2%. As does Van Eck Sustainable World Equal Weight (TSGB) which tracks 250 sustainable, equally weighted companies from across the globe.

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