How an equal-weighted index could respond to tech firms' tumbles

Following equal weighting rather than the traditional market cap has its benefits and costs

How an equal-weighted index could respond to tech firms' tumbles

Those invested heavily in the S&P 500 Communication Services Select Sector Index had a rude awakening in late July: following a disappointing earnings release on July 25, Facebook’s stock price plunged 21.35% over the next five days. During that time, the benchmark fell 7.02%, and around two thirds of the loss was due to Facebook.

“The S&P 500 Communication Services Select Sector Index has a definite concentration in Facebook,” wrote Nick Kalivas, senior equity product strategist at Invesco, in a recent blog post. “The company represented 21.73% of the index on June 25, which is why the company’s loss was so impactful.”

The outsized weight of Facebook, Kalivas explained, was due to the index’s market-cap-based weighting. To illustrate just how massive the effect of market-cap weighting is, he determined what would happen if the index had equal positions across all of its 26 holdings — that is, a 3.85% weight for each stock.

“Facebook’s late July loss would have had much less of an impact on the overall index. The index would have fallen 3.23% from July 25 to July 30, with Facebook representing 25.41% of that loss,” he said.

But an equal-weight strategy could be a double-edged sword: a negative shock to a minor constituent in a market-cap index would be even more impactful if the company were to get a bigger presence as a result of equal weighting.

“From July 25 to July 30, as Facebook lost 21.35%, Twitter declined even more — by 29.04%,” Kalivas said. But because it had only a 2.90% weight in the S&P 500 Communication Services Select Sector Index, it accounted for only 12% of the benchmark’s decline during that time.

If the index had been equally weighted across its holdings, Twitter would have had a higher weight of 3.5%. The impact of Twitter’s loss would also have been 34.55%, nearly three times as much as what actually occurred.

That may not sound like a good outcome from a performance perspective, but as Kalivas noted, equal-weight strategies aren’t designed with performance in mind. “Investors in market-cap-weighted indexes may not be quite as diversified as they think they are, due to concentration risk,” he said. “Equal weighting is a potential solution.”