Market cap- vs. equal-weighted indexes in the Magnificent Seven era

By the most common measure, the S&P 500 Index posted a 15.3% total return in the first six months of 2024. By another, the largest 500 U.S. stocks delivered one-third of that gain: 5.1%. What gives? It depends on whether performance is measured using a conventional market capitalization-weighted index—as in the case of the larger return figure—or an index using a less widely used method known as equal weighting.

As the numbers show, it can be a distinction with a major difference—especially in a time like now, when a narrow market segment has recently had an outsized impact on U.S. stock performance and dramatically reshaped the market’s composition. As of June 30, 2024, just seven technology-oriented stocks—Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla, often referred to as the Magnificent Seven—had grown so much that they represented 31% of the S&P 500 Index’s (S&P 500’s) total market capitalization.

With such a big weighting owing to sharp appreciation in their prices, the Magnificent Seven stocks accounted for 62.2% of the S&P 500’s 26.3% total return in full-year 2023. Excluding the 104.7% average return that those seven stocks generated, the index’s return was just 9.9%. The market’s top heaviness has recently become even more extreme, as those seven stocks accounted for 79.0% of the S&P 500’s total return in June 2024.

A challenge for traditional equity portfolio diversification and index-weighting methods

While the Magnificent Seven have commanded attention the past couple years, growing market concentration isn’t new. Over the 10-year period that ended in December 2023, the share of overall market capitalization attributed to the S&P 500’s 10 largest stocks nearly doubled from 14% to 27%.

Recent tech stock dominance has accelerated this trend and raised questions about the reduced level of equity diversification that an investor may be getting from investments tracking a seemingly broad index such as the S&P 500. These are three primary ways in which investors may find themselves with portfolio allocations that no longer align with their objectives:

1        Higher portfolio exposure to the tech sector, where advances in artificial intelligence have driven much of the Magnificent Seven stocks’ gains in 2023 and in 2024’s first half.

2        Higher exposure to the growth equity style—stocks exhibiting above-average growth rates that typically carry higher prices relative to earnings than the prices of less-expensive value stocks.

3        The increased exposure to tech and growth has left some investors relatively underexposed to value stocks. On the value side, companies’ earnings are generally steadier and slower growing than those of their growth counterparts, often reflecting the relatively long history of their business models and revenue sources.

In addition to diversification concerns, the Magnificent Seven’s dominance has fueled wider performance differentiation across the investment landscape; in many cases, funds that had overweight exposure to that small group of stocks over the past year or two were likely to have outperformed relative to peers that were underweight in some or all of those seven names. It’s important context to consider when analyzing recent performance, and it points to the need to drill down to understand what factors have been in play. If a stock fund or other investment underperformed, was the shortcoming chiefly due to its relatively high exposure to segments of its investment universe that didn’t fully participate in the Magnificent Seven’s recent run? If there’s a performance rotation and those recently hot stocks begin to lag, how might the picture change?

The conventional approach: market cap-weighted indexing

Many portfolios are heavily weighted today to the tech sector and the growth style as a result of the market capitalization weighting method that’s traditionally been employed for stock indexes. With this approach, the impact that each constituent stock has on overall index performance is weighted according to that stock’s market capitalization—a corporation’s value as determined by the market price of its issued and outstanding common stock.

As a result, the company with the largest market capitalization in an index such as the S&P 500 has a far bigger impact on overall index performance than that index’s 500^th largest stock. (As of June 30, 2024, the largest was Microsoft, with a 7.0% S&P 500 weighting and roughly $3.3 trillion market cap in an index with $48.2 trillion in total market cap; at the smallest end of the scale, a handful of companies were roughly tied with fluctuating weightings of around 0.01%.)

Moving up to the sector level, information technology’s weighting in the S&P 500 had grown to 32.4% as of June 30—by far the biggest among all 11 sectors, owing to tech’s market-leading total returns of 57.8% in 2023 and 27.8% in 2024’s first half.

Market cap weighting is the most common method of index construction, and it’s designed to accurately reflect changes in the market’s composition; if there’s a shift in a market segment’s value as reflected by stock price movements, the index’s composition reflects those changes as weightings are adjusted. Passive investments that seek to track such an index follow suit without an investor needing to rebalance.    

However, such an approach might not align with an investor’s portfolio objectives, whether an investor uses a passive investment or takes an active approach that attempts to outperform. Either way, there could be a need for periodic rebalancing to restore allocations to any parameters that may have been set to suit an investor’s risk tolerance and long-term investment goals.  

A lesser-known alternative: equal-weighted indexing

To address potential issues such as market concentration, high valuations, and sector bias, equal weighting is an alternative. Far less widely used than their market cap-weighted peers, equal-weighted indexes seek to be size-neutral. While the constituent stocks that make up an index are the same as with a market cap-weighted index, each stock is allocated the same weight rather than varied weights based on market cap. Because large and small stocks count the same in equal-weighted indexes, relative exposure to smaller companies is greater than it is with market cap-weighted indexes. Similarly, a portfolio’s weighting in companies with lower valuations increases, as does exposure to sectors that have smaller representation than in a market cap-weighted index.

For example, the market cap-weighted S&P 500 has an equal-weighted variant, the S&P 500 Equal Weight Index. Other index providers also offer equal-weighted versions of widely tracked equity indexes. Approaches can vary; for example, an equal-weighted index series offered by FTSE Russell equally weights each industry within an index and then equally weights the companies within each industry, rather than simply assigning an equal weight to each index constituent.

Potential weaknesses of equal-weighted index investing

While some investors have turned to equal-weighted investing approaches to pursue enhanced diversification, they don’t reflect the reality that some stocks are worth more than others or that markets shift. Moreover, such an approach may introduce its own set of risks. In recent years, underperformance has been a key issue, as the S&P 500 Index has consistently outpaced its equal-weight version.

In addition, equal-weighted approaches can result in increased—and potentially unintended―exposures to smaller stocks since they’re weighted equally to an index’s larger stocks. Furthermore, amplifying exposure to smaller stocks may leave an investor underweight in the momentum and quality factors. The momentum factor weights more heavily toward stocks with strong recent performance, based on the notion that performance tends to persist, with a stock’s price either continuing to rise or fall; the quality factor emphasizes resilient companies that have tended to demonstrate higher performance in challenging market environments owing to characteristics such as balance sheet strength and profit durability.  

The bottom line: know what you’re invested in

Whether using a conventional market cap-weighted approach or trying an equal-weighted alternative, investors should be aware of the potential risks and benefits involved with both options and know what they’re investing in. The recent dominance of the Magnificent Seven has put traditional market cap weighting under increased scrutiny, but—as with any investment—alternative approaches such as equal weighting may present their own risks that may not be easily apparent.