Huge sums of investor cash have poured into exchange-traded funds during this past year (and during the whole bull market) with billions of dollars sitting passively in funds betting on the very largest U.S. stocks.
But new research suggests this money is betting on funds with a methodology that might not offer the best returns for the regular person over the long term.
The weighting of stocks in most major indexes, and the ETFs tied to them, are based on market capitalization, meaning that big-company components can pull the index more than the little ones. For example, a 20 percent move in Apple can shift the entire S&P 500 by more than half a percent.
An equal-weighted index, on the other hand, treats all the companies equally in terms of how they can influence the group as a whole and in many cases, offered a better return to investors over the last 20 years, according to Pablo Fernandez, a finance professor at the University of Navarra in Spain.
For example, researchers there showed that if an investor had put $100 in the S&P 500 in January 2000, the sum would be worth $252.60 in April 2018; alternatively, $2.50 invested unweighted in the largest 40 companies in the S&P 1500 would be worth $273.10 in April 2018.
That disparity grows even more pronounced as the size of the companies shrinks: $5 invested unweighted in each of the 20 smallest companies in the S&P 1500 in January 2000 would now be worth at least $36,000.
To be sure, the numbers cited by the paper may be skewed slightly since large cap technology stocks were gutted in the Dotcom bubble bust of March 2000. And the return numbers alone do not represent associated risks for each index with smaller companies sometimes being much more volatile.
Still, this debate is not a new one and it’s worth analyzing given that many of the globe’s most popular ETFs use a market-weighted methodology.
The SPDR S&P 500 ETF (SPY) — the largest ETF on the market with $261 billion in assets under management — tracks a market-cap weighted index of the S&P 500. BlackRock, the largest asset manager in the world, runs the iShares Core S&P 500 ETF (IVV), another S&P 500-tracking fund.
Investors have poured more than $17 billion into that ETF over the past year, according to FactSet fund flow data; Vanguard’s S&P 500 fund drew nearly $12 billion over the same time.
“We document that unweighted indexes have outperformed weighted indexes and that the S&P 400 and the S&P 600 have outperformed the S&P 500,” the University of Navarra researchers wrote. The S&P 400 tracks midcaps while the S&P 600 tracks small caps.