Equal-Weight ETFs: A Simple Fix for Market Concentration

If you took a closer look at your portfolio today, there’s a fair chance you have a high concentration globally in tech stocks – specifically the Magnificent Seven – and domestically in banks and miners. 

After all, the Magnificent Seven represent over 20% of the MSCI World and more than a third of the S&P 500, while Australia’s Big Four Banks account for 22.7% of the S&P/ASX 200. Add BHP and Rio Tinto to that tally and you’ll see more than a third of the index is banks and miners. 

It leaves investors uncomfortably under-diversified and exposed to some of the big risks in the market, such as AI concerns and commodity trends, along with inflation and interest rates, which tend to hit the profits of banks. 

But how do you combat that in your portfolio? After all, the aim of using index ETFs is to add diversification, not leave yourself overly concentrated.  

One option may be equal-weighted ETFs. 

Key Takeaways 

• Global indices are heavily weighted towards large-cap tech firms, in particular the Magnificent Seven, which creates a concentration risk for investors. Domestic indices favour banks and mining stocks.  
• In an equal-weighted ETF, every company has the same allocation weight, regardless of its size. Standard indices base allocation weights on company size. 
• Equal-weighted ETFs can reduce concentration risk and increase diversification, as well as offering exposure to mid-sized and smaller companies. 
• The downsides of equal-weighting include higher turnover, tax implications from more frequent crystallisation of capital gains and higher exposure to market laggards.
  
  

Standard Index Weighting & Concentration Risk 

You may wonder how you’ve ended up with a concentration risk despite using a broad-based index ETF for diversification. The answer comes down to how the index is constructed and the weightings it uses. 

Broad-based market indices are weighted based on market capitalisation – the biggest companies receive the largest allocation weights in the index, and the smallest companies receive the smallest allocation weights. 

Given the Magnificent Seven companies are the largest in the world, you can start to see how they’ve dominated allocations in global indices, not just US indices.  

This also means returns are dominated by the larger allocations held by the larger companies. While this hasn’t been a bad thing in recent months with the strong outperformance of large-cap tech companies, this isn’t always the case and sometimes it may mean missing better performance in smaller companies or other sectors.  

An option to combat this is equal-weighting, which is a form of smart-beta.  

Equal-Weight to Adjust Concentration 

Equal-weighting simply means every company has the same size allocation in the index, regardless of any other characteristics, like market capitalisation. 

Consider the S&P/ASX 200.  

BHP is the largest Australian company by market capitalisation in the index and holds a weighting of 11.57%, while Weebit Nano is the smallest in the index with a weighting of 0.03%.  

In an equal-weighted strategy, both would hold the same weighting of 0.5%.  

More pointedly, the Big Four Banks move from being 22.7% of the exposure to 2% – it’s something to be aware of at a point where Australian banks, particularly Commonwealth Bank, are veering towards the expensive side of valuations and facing challenges to earnings from inflation, rising rates and a decline in the property market. It broadens your exposure to companies of different weights and sectors. 

Equal-weighting allows all companies to contribute equally to returns rather than being dominated by just the largest. If you factor in that, on the ASX alone, there are some stellar companies sitting further down the market capitalisation chain, like ResMed, Xero or Goodman Group, it means bigger exposure to their earnings and more diversification. 

Some examples of equal-weighted ETFs include VanEck Australian Equal Weight ETF (ASX: MVW) and Betashares S&P 500 Equal Weight ETF (ASX: QUS).  

Pros & Cons of Equal-Weighting 

While equal-weighted strategies can offer better market diversification and exposure to mid-sized and smaller companies, they can also have higher costs. 

Some of the positives include: 

• Reduced concentration risk by spreading allocations evenly regardless of company size. 
• Potential for outperformance in periods where small-cap stocks or value stocks rally. 
• Greater diversification across company sizes and sectors. 
• Automatic rebalancing (takes profits from winners, buys cheaper stocks automatically). 

Some of the negatives include: 

• Potentially higher turnover costs from rebalancing to equal weightings. 
• Tax implications from more frequent crystallisation of capital gains. 
• Can underperform in markets where outperformance is driven by a small selection of large-cap stocks (i.e. the Magnificent Seven). 
• May be more volatile as you have bigger exposure to weaker companies. 
  
  

Is an Equal-Weight ETF Right for Your Portfolio? 

Equal-weighting can help manage concentration risk in your portfolio, but it is not necessarily right for all investors, given that it is considered a contrarian approach (sell winners, buy market laggards). 

Typically, investors use these strategies to complement their existing core holdings, rather than to replace them – there are still advantages in market-capitalisation weighting. In a core-satellite portfolio, it might sit in the satellite component to offset concentration and add diversification. 

In a world where our markets are highly concentrated towards large-cap tech firms, it’s valuable to be aware of the options to reduce the risks of this exposure, and equal-weight ETFs can offer one solution. 

Frequently asked questions 

What is equal-weighting? 

Equal-weighting is where every asset allocation in an index is the same size, regardless of other factors. For example, the largest company will have the same size allocation as the smallest. 

Why do global and domestic indices have concentration risks? 

Global and domestic indices are typically weighted by market capitalisation, where the biggest companies hold the largest allocations in the index. This can result in investors being overly concentrated towards a particular sector or theme, such as in the current market, where the largest global companies are the tech firms known as the Magnificent Seven. 

How do equal-weighted indices reduce concentration risk? 

Equal-weighted indices spread allocations evenly, so no single company carries greater weight and influence on the index. Rather than investments being dominated by one particular sector where companies are the largest, companies from other sectors and of other market capitalisations have an equal influence on the overall performance. 

Which type of weighting is better: market-weighted or equal-weighted? 

Neither equal-weighted nor market-weighted is necessarily better. Each has characteristics that suit certain market cycles or certain investors and are often used to complement each other. For example, equal-weighted strategies might outperform in early market recoveries after a crash, or provide a buffer in a market with a bubble. Market-weighted strategies might outperform when the cycle is momentum- and growth-driven, in broad bull market cycles.  

Funds mentioned 

Disclaimer: This article is prepared by Sara Allen. It is for educational purposes only. While all reasonable care has been taken by the author in the preparation of this information, the author and InvestmentMarkets (Aust) Pty. Ltd. as publisher take no responsibility for any actions taken based on information contained herein or for any errors or omissions within it. Interested parties should seek independent professional advice prior to acting on any information presented. Please note past performance is not a reliable indicator of future performance.