Opinion: How Apple affects your index fund’s performance depends on this crucial investment decision

How much Apple AAPL,
-2.13%
the percentage share of an index fund suits you: 7.1%; 2.2% or 0.2%?

This question is at the heart of a debate between the two dominant schemes for assigning weights to stocks in an index: cap weighting and equal weighting.

The first, which is the most used and is used by indices such as the S&P 500 SPX,
-2.12%,
weights each stock by its market value. The larger the stock, the greater its weight in the portfolio. Equal weighting, on the other hand, assigns the same portfolio weighting to all component stocks, regardless of market capitalization.

Earlier this month, I wrote a column about an exchange-traded fund that is benchmarked to the equal weight version of the S&P 500 – Invesco S&P 500 Equal Weight ETF RSP,
-1.80%.
Because this ETF gives equal weight to each of the stocks in the S&P 500 index, Apple’s weight is 1-500and, or 0.2%. Meanwhile, in the cap-weighted SPDR S&P 500 Trust SPY,
-2.14%,
Apple shares represent 7.1% of the entire portfolio.

In that previous article, I pointed out that over the past five decades, both versions of this S&P 500 strategy have produced nearly identical risk-adjusted returns. The equal-weighted version performed better in raw terms, but with greater volatility or risk.

This column led to a question about another type of index weighting strategy, one in which each of the 11 major market sectors is given equal weight. This is the basis of ALPS Equal Sector Weight ETF EQL,
-1.42%.
Since a stock’s weight in a given sector is a function of its market capitalization, this approach is effectively a hybrid of capitalization weighting and equal weighting. Thus, in the ALPS ETF, Apple’s weight more recently represents 2.2% of its portfolio.

How does this hybrid approach work? Look at the chart above, which plots the relative strength over the past 20 years of the NYSE Equal Sector Weight Index (the index the EQL ETF is benchmarked against) against the S&P 500. Note that the index NYSE significantly outperformed the S&P 500 over the first half of this 20-year period, and just as significantly lagged the second half. For cumulative performance over 20 years, the two are almost exactly neck and neck.

What caused this 20-year round trip? The answer, according to Lawrence Tint, lies simply in the relative performance of different market sectors. Tint is the former US CEO of BGI, the organization that created iShares (now part of Blackrock). Tint has devoted much of his career to perfecting index funds. In an interview, he claimed that in the early years of this century, the sectors that performed better had a greater weight in the equally weighted sector index than in the capitalization-weighted index. Exactly the opposite has happened over the past decade.

These long stretches of above and below market performance were just luck of the draw, argued Tint. It could just as well have been the other way around. Unfortunately, he added, there is no way of knowing in advance whether the next few years will be like the last decade or the 10 years before it.

Tint says there’s one reason to expect traditional cap-weighted portfolios to take hold in the very long term: lower transaction costs. Indeed, no rebalancing is required when maintaining the capitalization weighting of an index fund. With equal weighting – whether it is each stock that is equally weighted or each sector – frequent rebalancing should be undertaken to ensure that no one stock or sector takes on too much or too little weight in the portfolio. Although the transaction costs involved in rebalancing are not huge, they can accumulate over many years.

The bottom line? Apple and other large-cap stocks may or may not outperform the market in coming years. If they beat the market, you’ll be glad you invested in a market-cap-weighted index fund. If they’re rather late to the market, you’ll want to have one of the equally weighted versions.

Mark Hulbert is a regular MarketWatch contributor. His Hulbert Ratings tracks investment newsletters that pay a fixed fee to be audited. He can be reached at [email protected]

Continued: This unprecedented evidence shows that value stocks have been beating growth stocks for much longer than we knew

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