One of two methods is usually used to construct indices and the funds that track them
What difference does the one you select make?
When purchasing an exchange-traded fund (ETF) or index fund that tracks a specific index, you have two primary options.
All of the components (bonds or shares) in an equal-weighted index fund have the same size.
On the other hand, a market cap-weighted index fund allocates proportionately, meaning that the stock or bonds of larger companies make up a larger share of the index, while the stock or bonds of smaller companies make up a smaller amount.
Some may argue that using market capitalization to allocate each index component seems a little shortsighted if the goal of an index fund is to have diverse exposure to many different companies (100 in the flagship FTSE index, 500 if it's the US S&P equivalent, and so on).
Watch the full video here: If you're a US index investor, purchasing a fund that tracks the S&P 500 index should grant you access to 500 shares (it's actually slightly over that 505 at the end of July because some companies, like Alphabet, the parent company of Google, list multiple share classes of their stock). However, with a combined market capitalization of about £22 trillion, the so-called Magnificent 7 (Mag 7) names make up about a third of the S&P's value.
That concentration is indicative of the sector's place in the market and economic function as a stand-in for the larger US stock market. However, as an investment vehicle that serves as a one-stop shop for a diversified index, it begs the question of whether this strategy has any drawbacks.
In the end, it is up to you which strategy you prefer, but there are reasons to support both.
Why is it important to compare equal- versus market-cap-weighted?
The primary distinctions pertain to performance, rebalancing, and portfolio characteristics.
Many investors may have applauded the Mag 7's dominance when they were soaring. However, those stocks' performance is currently declining, which highlights the concentration risk they have posed.
For the first time since 2022, all of the Mag 7 stocks have underperformed the index, according to ETF provider HANetf.
According to Mark Preskett, senior portfolio manager at Morningstar Wealth, equal-weighted indices can differ significantly from market cap-weighted ones in that they are more evenly distributed across other industries, including healthcare, industrials, energy, and finance, and have significantly less exposure to technology. They shift away from megacap growth and toward a less lucrative, less expensive segment of the market, he continued.
A company's share of the index increases with its size, which inevitably draws more investment thru funds that track the benchmark. In other words, since they are already the winners, they continue to grow.
A compelling investment case is created when those businesses are outperforming. The opposite is true, tho, when things are unstable. This is known as concentration risk. Hundreds of names may still be included in a broad index, but its effectiveness is dependent on a small number of significant constituents.
What is the comparison of performance?
There can be significant differences in the two strategies' growth potential.
Morningstar examined the gross returns in US dollars over a ten-year period (1 August 2016 to 1 August 2026) of its Global Target Market Exposure (TME) Equal Weighted index fund, which tracks the gross returns of the top 85 percent largest mid- and large-cap global stocks (equal-weighted). It started with £10,000 and increased to £23,041 with a cumulative return of 130.68 percent.
Over the same period, the market cap-weighted peer produced a cumulative return of 224.68 percent, converting £10,000 into £33,360.
The trade-off investors are making is highlighted by this striking disparity. Giving more exposure to mid-cap value traits and less to the megacap names that drive the market-cap indices can be achieved thru equal weighting. However, the winners of the market cap-weighted index have produced much greater returns.
According to Morningstar Indexes' global head of product and research, Rob Edwards, this is not a recent development. He cited long-term data that indicates returns are frequently driven by a relatively small number of businesses.
Hendrik Bessembinder of Arizona State University's business school examined 29,754 stocks between 1926 and 2025, a period during which £91 trillion in shareholder wealth was generated. Half of that total wealth creation came from just 46 businesses.
However, Cameron MacDonald of HANetf stated that the case for equal weighting is supported by skepticism regarding artificial intelligence spending, a shift into smaller businesses, and conflicting recent Mag 7 results.
Invesco, which also provides equal-weighted index strategies, cited FactSet data to show that between 1999 and 2023, the equal-weight version of the S&P 500 index beat its market cap-weighted counterpart by an average of 1.05 percent per year.
Advantages of weighting equally.
One could argue that the breadth of underlying company nuances is what you are looking for if diversification is the goal of investing in a wide index.
Morningstar reports that 120 billion (103 billion), or 65% of all European asset flows, went into passive funds in the first quarter of the year. With more money going into stocks thru exchange-traded funds (ETFs) and passive funds, there's a chance that a market cap-weighted strategy will reward the winners and unintentionally fail to support the smaller businesseswhich could be future winnersto the extent you would like.
Equal-weighted funds' supporters make this argument. They lessen the impact of the biggest names and give the smaller constituents a greater role in the portfolio. In reality, this frequently entails focusing less on technology and more on the financial, medical, industrial, and energy sectors.
"Rather than megacap growth, you're getting materially different outcomes and sector biases, about 10 times the market cap and almost a mid-cap value as a style," stated Preskett.
Additionally, those smaller stocks are less expensive; their price-to-book and P/E multiples are lower, but they are frequently less profitable.
He recognizes the potential for more tactical application of equal-weighted strategies. Peers appeared to be more interested in equally weighted portfolios as the markets became more concentrated earlier this year. They were perceived as a means of reducing risk and, in a sense, smoothing returns by introducing a much more diverse subset."
However, it wasn't a long-term approach his team would suggest for mainstream clients beyond such tactical use.
Edwards added that he didn't agree with the notion that long-term results are distorted by surging passive flows.
"I am aware that there has been a narrative for academic summaries on this, but I believe the long-term reality is that a company won't continue to grow if it doesn't have strong fundamentals, financials, and growth characteristics."
The winners are the winners due to their extraordinarily large moats, as well as their businesses' remarkable scale, cost effectiveness, and network effects.
"The construction of indexes has very little bearing on the long-term growth of share prices. Since active management will always exist, I don't think you can point to index construction or the growth of passive investing."
When stocks become overpriced, active management can help stop the momentum.
The decision between market-cap-weighted and equal-cap funds ultimately comes down to your goals. These are two very distinct approaches. Market cap-weighting continues to be the standard for capturing the market as it is.
If youre hoping to reduce concentration and spread risk more evenly across the index, that makes a case for equal weighting.
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