Equal-weight vs market-cap index funds: what "the index" means

An index fund tracks an index, and every index has a rule for how much of each company it holds. The default rule is market value: the largest company receives the largest weight, and a handful of giants end up deciding how the whole thing performs. Conventional S&P 500 trackers work this way.

One alternative gives every company in the index the same share. Every quarter the fund sells part of whatever has run up and buys more of whatever has lagged, until each of the 500 is back at 0.2% of the fund. Same 500 companies, a different answer to how much of each to own.

Through late August, on the Wall Street Journal's figures, the equal-weighted version of the S&P 500 was up 16.3% for the year against 13.5% for the standard one. Part of the reason is that the biggest American companies, the ones that dominate the standard index, lagged the rest of the market this year. The gap ran the same way in the Nasdaq-100, 20.2% against 17.1%. Over the past decade, and over the past twelve months, it has run the other way, with the standard index ahead.

Equal weighting also costs the holder more. The annual fee is around 20 basis points, or 0.2% of the amount invested, against three basis points at the cheapest conventional trackers. That is paid whichever way the market goes.

The trade-off is straightforward. Equal weighting spreads exposure more evenly but costs more and requires regular rebalancing. Market-value weighting is cheaper, although a handful of very large companies can dominate the result. Two funds can carry the same index name while giving their investors materially different exposure.