Equal-Weighting S&P 500
app, asset allocation, exchange-traded fund, market, portfolio

The popular market-proxy S&P 500® index is market-cap weighted. This is one of the factors that helps reduce the turnover of ETFs tracking this index. For example, the iShares Core S&P 500 ETF (IVV) has a turnover rate of only 4%. The following chart, produced by the Alpholio™ App for Android, shows the characteristics of a portfolio composed solely of this ETF:

Portfolio 100% iShares Core S&P 500 ETF (IVV)

(Note that Alpholio™ uses a broader ETF as a representation of “the market”; hence, the beta of IVV is different from the conventional one and alpha from zero.)

However, market-cap weighting implies that the largest companies’ stocks have the highest impact on the index. While returns of mega-caps in the index tend to be less volatile, they are usually lower than those of their smaller-cap peers. To overcome this limitation, other ETFs weight equities in the index differently. For example, the Guggenheim S&P 500™ Equal Weight ETF (RSP) assigns each of the 500 stocks a 0.2% weight. This tilts RSP toward smaller-cap equities in the index and results in a 18% turnover. Over the same analysis period, RSP produced markedly higher returns than IVV but at the expense of an elevated volatility and a slightly lower Sharpe ratio:

Portfolio 100% Guggenheim S&P 500® Equal Weight ETF (RSP)

In addition to overweighting of mega-caps, some economic sectors in the index dominate others, as shown in the latest edition of S&P Capital IQ The Outlook:

Sector Weight %
Consumer Discretionary 12.7
Consumer Staples 9.4
Energy 7.8
Financials 16.5
Health Care 15.3
Industrials 10.2
Information Technology 19.9
Materials 3.2
Telecommunication Services 2.2
Utilities 2.9

To counteract this, the ALPS Equal Sector Weight ETF (EQL) applies the same weight to nine sectors (with telecommunication services considered part of information technology). Here are the characteristics of a portfolio consisting solely of this ETF over the identical analysis period:

Portfolio 100% ALPS Equal Sector Weight ETF (EQL)

While the annualized return of EQL was lower than than of IVV or RSP, it was more than adequately offset by a decrease in volatility, which resulted in an improved Sharpe ratio and maximum drawdown.

What if the investor wanted to equal-weight all ten sectors instead of just nine, i.e. keep telecoms separate from IT? To do so, the investor could construct a portfolio of Vanguard sector ETFs, excluding the Vanguard REIT ETF (VNQ). That is because real estate stocks are currently part of the financials sector and not expected to become a separate asset class until mid-2016. Here is how such a portfolio, rebalanced quarterly (just like EQL), performed over the same analysis period:

Portfolio Vanguard Sector (VCR, VDC, VDE, VFH, VHT, VIS, VGT, VAW, VOX, VPU)

The Vanguard sector portfolio had the second highest alpha and Sharpe ratio as well as the second lowest standard deviation (a measure of volatility of returns).

The above analysis period was dictated by the inception date of the EQL, the youngest of all the ETFs used. Arguably, this approximately six-year period may be considered too short and not representative of performance over a full economic cycle. However, it was interesting to see that while equal-weighting the index on a security level produced highest absolute returns, equal-weighting on a sector-level delivered the highest risk-adjusted returns.

To conduct your own analyses of various ETF portfolios, download the Alpholio™ app from

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Year-End Market Predictions
market

At year’s end, many analysts make market predictions for the next twelve months. The S&P 500® index is a popular target for such forecasts since it is commonly used as a market proxy and its constituent stocks are widely followed. Hence the bottom-up analysis — a sum of estimates for all individual equities makes an index forecast.

Who better to predict the S&P 500® index level than the S&P itself? Let’s take a closer look at their forecast accuracy. The following chart compares the predicted to actual values of the index, which Alpholio™ compiled from historical editions of S&P Capital IQ’s The Outlook:

S&P 500® Prediction vs. Actual

To be exact, these 12-month targets were typically set in early to mid December of the preceding year, while the actual index values were recorded on the last trading day of the predicted year. Also, dividends were not taken into account in this price index.

The immediate takeaway from this chart is that the forecast for 2008 vastly overestimated the actual price: 1,650 vs. 903, or by about 83%! The financial crisis and its magnitude caught everyone, including members of the S&P Capital IQ’s Investment Policy Committee, by surprise. Excluding that outlier year, here are the index prediction and annual return statistics:

Statistic Prediction vs. Actual Actual Index Return
Average -2.2% 11.8%
Median -1.8% 13.1%
Standard Deviation 5.8% 9.2%

The sample is admittedly small, under ten data points. But a trend is emerging — on average, S&P predictions underestimated the actual index. This tendency is further illustrated by the following chart from FactSet’s Targets & Ratings report:

FactSet - S&P 500® Ratings, Target and Closing Price - 12-Month

The chart shows how a bottom-up target price (dashed line) moved almost in parallel with the actual index (solid line) in the 12 months through October. In other words, predictions were adjusted upwards with a lag as it became evident that original estimates were likely going to be soon surpassed. (As a side observation, almost half the stocks in the S&P 500® were rated a Buy, slightly less than half a Hold, and only about 5% a Sell. Even a booming market, a less optimistic distribution would be intuitively expected.)

S&P offers another interesting prediction for the next year:

We also believe 2014 could be one of those years in which the S&P 500 is up for the entire year but suffers through a pullback of 5%-10% (and more likely a correction of 10%-20%) before ending the year higher than where it started. One reason is that 26 months have elapsed without the S&P 500 slipping into a correction, versus the average of 18 months (and median of 12 months) between declines of 10% or more since 1945.

If statistically the market is overdue for a correction, let’s also hope that by the same token S&P underestimated the 500® index’s value in 12 months from now. In that case, we should be expecting a price of about 1930 instead of the current target of 1895, while keeping in mind that perfect market predictions are virtually impossible.

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