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The Right And Wrong Ways To Index.

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Over the long term, the equally-weighted S&P 500 index has outperformed the cap-weighted index by 1.2% per year. However, there have been periods during which the cap-weighted index massively outperformed the equally-weighted index. This article describes what investors should do now.

The purpose of the stock market is to allocate capital according to an ever-changing optimum among three variables:
1)  The return on invested capital of an asset.
2)  The growth rate of the ROIC on this asset.
3)  The market price of the asset.

Identifying this optimum at any one point in time is hard. Imagine that like many investors I conclude that I am not equipped to do all the work necessary to identify and build an optimum position. Is the solution to index my portfolio? The answer is: it depends how I do it.
If my objective is to capture the long-term growth of US companies, then in broad terms I have a choice between two indexes:

  • The equally-weighted S&P 500
  • The capitalization-weighted S&P 500

In each case, I will own exactly the same companies. The difference is that in the first case, each company will make up 1/500 of my portfolio by value; in the second case, a third of my portfolio will be concentrated in just 10 stocks. Historically, which has been the better strategy? The answer is shown in the upper chart that follows.

market cap weighted vs equal-weighed index
Figure 1) Ratio of market cap weighted and equally weighted index
Source: Gavekal Research

Two observations leap out:

1) Over the long term, the equally-weighted index has outperformed the cap-weighted index by 1.2% per year.
2) However, there have been two periods—from 1994 to 1999 and again from 2017 to 2022—during which the cap-weighted index massively outperformed the equally-weighted index.

I have argued before that Buying a market-cap-weighted index is just momentum investing: the higher the price of an asset goes, the more of that asset you buy. And as we know, momentum investing always leads to bubbles. So it should follow that the periods when the cap-weighted index outperformed the equally-weighted index—when there were relative bubbles in the cap-weighted index versus the equally-weighted—should coincide with absolute bubbles in the stock market.

Cap-weighted indexation is momentum investing, and must lead to bubbles.
Charles Gave

Now, by great good fortune, I have already built a tool to determine whether or not the market is in an absolute bubble. Sure enough, relative bubbles coincide with absolute bubbles.

relative bubble coincide with absolute bubbles
Figure 2) Stock market bubbles
Source: Gavekal Research

So, what is the explanation for this phenomenon?

  • If you buy the equally-weighted S&P 500, you are getting the average ROIC, the average growth rate of ROIC, and the average market price for constituent stocks. By and large, this is OK.
  • If you buy the cap-weighted S&P 500, at first you get a higher ROIC and a faster growth rate of ROIC. But pretty soon you will be overpaying for shares in the companies that deliver this superior ROIC and faster growth.

However, as long as the prices for the shares in these remarkable companies are going up, money will flow out of actively-managed portfolios and out of the equally-weighted index and into the cap-weighted index. Since there is no natural return-to-the-mean mechanism as there is for the equally-weighted index, the cap-weighted index will first go into a relative bubble, and then into an absolute bubble. And eventually, when investors start to realize that some of these companies really cannot be considered “one-decision stocks,” the market will crash. And at this point, the only thing that will threaten to interrupt the relative crash will be a recession, since big caps tend to do better than small caps in recessions.


To sum up: If you must be indexed, then buy the equally-weighted index and sell the cap-weighted index. There is still plenty of relative downward risk for the market-capitalization index against the equally-weighted index— around -20% judging by the current deviation from the long term mean.

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