- Learn about capitalization levels in the U.S. equity market and the drawbacks of market-cap weighting
- Understand how equal-weighted indexes outperform traditional market-cap-weighted indexes
- Discover a five-index approach for meaningful exposure across various market-cap layers
This article is for investors who desire broad exposure to the various levels of “capitalization” in the U.S. equity market. In other words, you want an investing approach that provides meaningful exposure to huge companies, medium-sized companies and small/micro companies.
The term capitalization is often shortened to “cap” and is a way of describing the size of companies. Large-cap = large capitalization; mid-cap = medium capitalization, etc. Market cap is calculated by multiplying the number of shares outstanding by the share price of the stock. It reflects the total market value of a firm’s outstanding shares.
Market-Cap Weighting Versus Equal Weighting
The investing approach described here solves a problem that is inherent in mutual funds and exchange-traded funds (ETFs) that mimic the S&P 500 index, which is the most popular U.S. equity index. The S&P 500 focuses exclusively on large companies and is market-capitalization weighted. This means that the largest companies in the index are weighted much more heavily than smaller large-cap companies. As of early 2024, nearly 31% of the return of the S&P 500 was determined by the performance of the index’s largest 10 stocks. In other words, the largest 10 stocks (2% of the 500 stocks in the index) determine 31% of the overall performance of the index.
The performance of the two largest holdings [Apple Inc. 
(AAPL) and Microsoft Corp. (MSFT)] account for roughly 14% of the total percentage return of the S&P 500. Is this a problem? As long as the largest 10 companies perform well, it’s clearly not a problem. If they stumble, however, then it could be a big problem. This is because the poor performance of only a few stocks—the few really BIG companies—will disproportionately impact the overall return of the index.
Indexes—and funds mimicking those indexes—that employ market-cap weighting place a lot of eggs in very few baskets, so to speak. A visual illustration of market-cap weighting versus equal weighting is shown by the two “quilt” images in Figures 1 and 2. The size of each colored box represents the weighting or percentage allocation assigned to each stock in the S&P 500 (as of late 2023). The performance of the smallest weighted stocks (in the bottom-right corner of Figure 1) has very little impact on the S&P 500’s return.
In an equally weighted index, every company has an equal impact on the overall return of the index, as shown in Figure 2. Over the past 53 years (1971–2023), the S&P 500 Equal Weight index has annually outperformed the traditional market-cap-weighted S&P 500 54.7% of the time. It has also produced a 53-year average annualized return of 12.3% versus 10.8% for the market-cap-weighted S&P 500. Over the past 25 years (1999–2023), the annualized return of the S&P 500 Equal Weight was 9.5%, compared to 7.6% for the market-cap-weighted S&P 500. Over the past 10 years (2014–2023), the market-cap-weighted S&P 500 had a 12.0% return versus 10.4% for the S&P 500 Equal Weight.
Solving the Distortions Caused by Market-Cap Weighting
Let me propose a possible solution to the distortions caused by market-cap weighting: Use several mutual funds or ETFs that individually focus on the various layers of capitalization in the U.S. equity market. In this way, we gain meaningful exposure to companies of all sizes.
To demonstrate the benefit of this approach, I’ve identified five indexes that represent various capitalization layers of the U.S. equity market as well as growth and value orientations. The five indexes are shown in Figure 3. A 22-year performance comparison of these five indexes versus the market-cap-weighted S&P 500 is provided in Table 1.
As shown, the five indexes (equally weighted at 20% each and annually rebalanced) outperformed the S&P 500 by six basis points (0.06 percentage points) on an average annualized basis over the 22-year period from 2002 through 2023. Plus, the five-index approach experienced slightly less volatility (as measured by the standard deviation of annual returns). The margin of outperformance using a five-index approach was particularly notable (nearly $700,000) in a retirement account analysis when money was being withdrawn each year. The virtue of broad diversification is particularly important for retirees due to the simple fact that money is being withdrawn—a burden made safer when there are diverse “buckets” (funds) from which to make those withdrawals.
Genuine diversification across the various segments of the U.S. equity market is a prudent investment philosophy both in the accumulation years and during the retirement years. The importance of being broadly diversified across multiple mutual funds and/or ETFs during retirement is particularly crucial. Doing so gives a retiree the ability to withdraw money from the best-performing funds each year.
Investment Options for the Five-Index Approach
Since it’s not possible to invest in raw indexes, actual ETFs that might be used in this type of five-fund approach are the Vanguard Mega Cap Value Index ETF (MGV), the Vanguard Mega Cap Growth Index ETF (MGK), the Invesco S&P MidCap Quality ETF (XMHQ), the First Trust Dow Jones Select MicroCap Index ETF (FDM) and the Invesco Dorsey Wright SmallCap Momentum ETF (DWAS). For those who prefer mutual funds, the Homestead Value fund (HOVLX), the Marsico Focus fund (MFOCX), the Fidelity Stock Selector Mid Cap fund (FSSMX), the Bridgeway Small-Cap Value fund (BRSVX) and the WesMark Small Company fund (WMKSX) are worthy candidates.
Discussion
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