S&P 500 Equal-Weight Trading Strategy: Backtesting and Practical Example

In January 2003, the S&P 500 Equal Weight Index (EWI) was created, and since then, you can trade ETFs that track the index. But what does this equal weight S&P 500 index mean?

As the name implies, the EWI is an equal-weight version of the popular S&P 500 Index. But instead of weighting each stock in the index based on its market, every stock is given equal weight in the index. There are many ETFs that track the EWI through which you can invest in the index. History shows that the S&P 500 equal weight index has outperformed the S&P 500 market weight index. We make an S&P 500 equal-weight trading strategy.

Let’s take a look at the S&P 500 equal-weight index and how it is different from the traditional S&P 500 index:

What is the S&P 500 equal-weight index?

Created in 2003 by Standard & Poor’s, the S&P 500 Equal Weight index is an index of the top 500 companies in the US, but instead of weighting each company in the index based on its size — as it is with the traditional, market-cap-weighted S&P 500 index — every company is given equal weight in the index.

In other words, both S&P 500 index types have the same component stocks but the weighting formula is changed — every stock in the index has the same weight, regardless of how large or small the company is. So, even Apple, the largest stock in the US, has the same weight as the smallest company in the index.

This simple change to the weighting formula changes the results drastically — the returns are not the same. The sector weight is a direct function of the number of companies in the sector. For example, if a sector contains 45 stocks, then the weight of the sector would theoretically be (45 / 500) x 100 = 9%.

The S&P 500 is heavily tilted to the few biggest mega-caps and thus they make a huge part of the total returns.

How is it different from the S&P 500 index?

The traditional S&P 500 index is weighted by the market capitalization of the component stocks. So, stocks with the largest market capitalizations or the biggest values, have the highest weights in the index. The weight of a stock in the index is equal to the market cap of that stock divided by the total market cap of all the stocks in the index. And, the sector weight is calculated by summing up the individual weights of the companies that will make up that sector.

For the S&P 500 Equal Weight Index, on the other hand, each of the component stocks is weighted equally. While the S&P 500 EWI includes the same constituents as the market-capitalization-weighted S&P 500, each company in EWI is allocated a fixed weight — 0.2% of the index total at each quarterly rebalance.

To understand the difference between the two indexes, think of the S&P 500 like a pie chart: In the market-cap-weighted index, the pie is broken up into slices (component companies) based on market cap, but in the equal-weight index, all the slices are the same size, regardless of the size of the company.

S&P 500 equal-weight ETF

There are ETFs that track each of the two indexes — the Invesco S&P 500 Equal Weight ETF (RSP) tracks the EWI, while the State Street SPDR S&P 500 (SPY) tracks the market-weighted index. The latter is the oldest ETF still trading (from 1993).

Although these two ETFs invest in the same companies, they can behave very differently. While both RSP and SPY need to be adjusted periodically to ensure they contain only the qualifying top 500 companies in the US, the RSP needs to be rebalanced to maintain equal weighting. Interestingly, equal-weight ETFs offer more protection when the large tech companies in the indexes experience a downturn — due to the equal weighting, the smaller companies can offset the losses from the bigger companies.

S&P 500 Equal-Weight Trading Strategy

Let’s look at a simple S&P 500 equal-weight trading strategy: we simply own the equal-weight index instead of the S&P 500 equal-weight. The equal-weighted index has outperformed the market-weighted index historically, but not in the last decade.

Why have equal-weighted stocks outperformed market-weighted ones?

We believe the reason is pretty straightforward: the small-cap effect. Maintaining a high growth rate becomes harder the bigger the company gets. Thus, over time the smaller weighted stocks in the S&P 500 have grown at faster rates, and thereby generated greater stock performance than their largest peers.

We see the same effect in S&P 500 vs S&P 100: the S&P 500 outperforms S&P 100.

Let’s look at the performance of RSP (equal-weight ETF) vs SPY (market-weight ETF):

A 10 000 investment in RSP in 2004 grows to 60 000 18 years later and “only” 55 000 for SPY (dividends reinvested). The difference should have been bigger because RSP has an expense ratio of 0.2% annually, while SPY has a much lower expense ratio of 0.0945%. The difference might sound small, but over 18 years it makes a difference.

The chart below shows the INDEX of the equal-weight vs market-weight:

As you can see, the difference gets bigger and bigger as time pass.

Let’s look at the daily differential returns between RSP and SPY:

The blue bars show the difference of the daily returns for RSP and SPY. If RSP rises 1% and SPY only 0.8%, it means the difference is 0.2% (the chart has absolute values). The blue bars are the daily absolute return differentials in percent, while the red bars show the 100-day moving average. In times of turbulence, like 2008 and 2020, there are daily huge differences between the two ETFs.

S&P 500 Equal-Weight Trading Strategy – ending remarks

We are not surprised that an equal-weighted index beats a market-weighted one. This is well known in the industry. However, most equal-weighted ETFs and mutual funds charge slightly higher expense ratios that lowers the difference somewhat.

FAQ:

How does the S&P 500 Equal Weight Index differ from the traditional S&P 500?

Unlike the traditional S&P 500, which weights companies based on market capitalization, the Equal Weight Index allocates an equal weight to each company. This equal weighting leads to a different distribution of returns, making it distinct from the market-cap-weighted counterpart.

How does the performance of S&P 500 Equal Weight ETF (RSP) compare to the traditional S&P 500 ETF (SPY)?

The S&P 500 Equal Weight Index is an index created in 2003, offering an alternative to the traditional market-cap-weighted S&P 500. Historical data suggests that the RSP, representing the equal-weighted index, has outperformed the SPY, which tracks the market-weighted index. This outperformance is attributed to the small-cap effect, where smaller companies within the index tend to grow at faster rates.

Why does the S&P 500 Equal Weight Index historically outperform the market-weighted index?

The historical outperformance is attributed to the small-cap effect and the consistent growth of smaller weighted stocks within the index. As companies grow, maintaining high growth rates becomes more challenging for larger companies, favoring the performance of smaller ones. While equal-weighted ETFs may outperform, some may have slightly higher expense ratios compared to market-weighted counterparts.