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How to weigh a stock portfolio by capitalization and sector

Overview of different approaches to diversification

A passive investor may find it difficult to build a portfolio.

The portfolio must be reliable, consistent with strategic objectives and not inferior to the index. In the case of the U.S. market, it is usually compared to the S&P 500.

If we lose to the broad market at a distance, then making an individual portfolio out of stocks may lose all meaning: it’s easier to invest in the index itself through an appropriate investment fund. Yes, there will be some minor losses due to management fees, but investments will grow along with the market and you won’t have to spend time on them. Another good option is simply to copy the index, repeating the list of securities in similar proportions.

But even in these cases there is a dilemma: there are two versions of the S&P 500 Index, weighted differently. Which one should we focus on? We will answer this question a little later.

I refer to myself as an active investor: I prefer to assemble a stock portfolio on my own to be able to fine-tune it. First of all, I have time and I am wildly interested in it. Secondly, I don’t want to invest in companies that I don’t like for some reason. After all, in the index, in this honeycomb of blue chips, you get a kind of spoonful of tar – companies with poor performance. Third, why not try to outperform the index?

When I was organizing my portfolio, I ran into a number of issues:

  1. How do you distribute your shares – in equal shares or according to the size of the company?
  2. Which of these approaches is better for large-, mid-cap and small-cap companies?
  3. In what proportion should the portfolio be divided into 11 sectors?
  4. How to make the portfolio technological, consistent with progressive trends?
  5. Based on the sectors, which internal division of assets is preferable in each of them?

On all these points I will try to give a detailed answer in the article – or at least show the direction of thought, which may be useful to the investor.

Ways to weigh the index

There are two approaches to forming indices: capitalization-weighted, cap-weighted, and equilibrium-weighted. The same principles can be applied to your stock portfolio.

In the first case, the share of the company corresponds to its capitalization: the more expensive the company, the greater its share in the portfolio. In the second case, all assets are placed in roughly equal shares.

The popular version of the S&P 500 is just weighted by capitalization, with the top 10 companies accounting for 25% of the index. Accordingly, they largely determine its behavior. And if you look at the end of the S&P 500 list, companies are only a hundredth of a percent there.

There is also an equilibrium version of the index, the S&P 500 Equal Weight. In it, each paper takes an equal share – from 0.1 to 0.3%. No one company prevails over the other, nor does it become the flagship of the portfolio. Such an approach to portfolio composition is quite strongly reflected in its dynamics.

In 2003, Invesco launched the Invesco S&P 500 Equal Weight ETF (RSP), which follows the equilibrium index. This fund has approximately $15 billion under management and a 0.2% management fee. Invesco also offers equilibrium ETFs for each of 11 sectors – we’ll look at those later – as well as funds for mid-cap and small-cap indices:

  1. Invesco S&P MidCap 400 Equal Weight ETF (EWMC).
  2. Invesco SmallCap 600 Equal Weight ETF (EWSC).

Let me remind you that companies are classified by capitalization:

  1. Small – up to $2 billion.
  2. The average is $2 billion to $10 billion.
  3. The big one is over $10 billion.
  4. Mega is from $200 billion.

Thanks to Invesco’s ETF, we can assess how the equilibrium methodology performs over a historical distance of 17 years.

Throughout this time, the equilibrium index was outpacing the normal index. However, the March collapse due to the coronavirus pandemic all but erased this difference in the moment. A similar technical pattern was observed during the 2008 crisis.

We can state that the equilibrium index is more volatile. This is due to its sectoral structure, as well as its focus on mid-cap companies: their shares fall harder in turbulent times, but give better results in a rising market.

At the same time, if we consider a period of less than 10 years, the common S&P 500 outperforms the equilibrium one, especially in the last five years. This is due to the rapid growth of technology giants, whose share in the index is very large, as well as the period of active buybacks – the repurchase by large companies of their shares.

If we look further back, however, we can see that a longer time horizon increases the advantage of the equilibrium strategy. The Wilshire data allow us to trace the behavior of both indices since 1978. They show that including dividend reinvestment, the equilibrium S&P rose at an average annualized rate of 12.5%, while the regular S&P rose at an average annualized rate of 11.4%. If we extrapolate this data over 42 years, we get an overwhelming difference:

42 × 1,1% = 46,2%

That is, the equilibrium method is almost twice as fast as the usual index. This makes us take it seriously and perhaps try to implement it in practice. However, with a glance at its disadvantages, which we will now consider.

Pros and cons of the equilibrium portfolio

Pros:

  1. Balance of power. Companies of both large and smaller capitalization give the same impetus to the portfolio when assets grow. In a growing market, this gives a synergistic effect – the index gets acceleration.
  2. Smoothes out the bad results of big companies.
  3. The degree of diversification is higher. Better insurance against force majeure with the big players, such as in the case of Lehman Brothers in 2008.
  4. More emphasis on mid- and small-cap companies with undiscovered growth potential. The equilibrium methodology naturally embodies the value-based investment strategy of betting on undervalued companies.
  5. At a distance of a few decades, you can get double the result. The difference is enormous.

Cons:

  1. The higher cost of maintaining an equilibrium fund because of frequent rebalancing. A regular ETF adjusts the portfolio only when major changes occur, while an equal-weighted fund is constantly forced to maintain balance.
  2. Increased annual average volatility – 16.79% vs. 14.23% for the competitor.
  3. Too small a share of the technology sector, which carries the banner of scientific and technological progress and shows rapid growth.

Another important observation: the equilibrium approach does not work with mid- and small-cap indices. When comparing the aforementioned EWMC and EWSC with capitalization-weighted competitors, the former lose. This is due to the more venture-like nature of mid-cap and small-cap stocks: list leaders shoot up more often and harder, so in such portfolios you have to bet more heavily on favorites, and that involves capitalization weighting.

Let us summarize the intermediate results:

  1. If you’re building a portfolio of the top 500 stocks, weighing assets equally may be more advantageous.
  2. At 10 to 40 years, the equilibrium portfolio strongly outperforms the normal portfolio.
  3. This approach does not work in the case of mid- and small-cap indices.
  4. It is necessary to take into account the increased volatility of the equilibrium index.

Sectoral structure of indices

To understand why the equilibrium portfolio goes into such a deep correction in a crisis scenario, let’s look at the sector structure in both indices. I wrote about what the sectors are and what they include in another article.

The IT sector has a gigantic 26.2% share in the S&P 500. Not surprisingly, the index has boomed over the past five years. Moreover, during the March crash, this sector kept the index afloat. Looking at the dynamics from January to early June 2020, with the overall S&P 500 down 1.1%, the technology sector was up 10.6%.

At the same time, the S&P 500 has a smaller share of the energy sector, which has fallen catastrophically since the beginning of the year – by 26.3%.

An additional factor that lends stability to this index is the increased share of the non-cyclical Health Care and Consumer Staples sectors. The only exception is Utilities: the share of this sector is larger in the equilibrium portfolio, the RSP.

Share of non-cyclical sectors in the classic and equilibrium S&P 500

Protective sectorsShare in the S&P 500Share in RSP
Health Care15,2%11,42%
Consumer Staples7,1%5,84%
Utilities3,2%4,96%

The Communication Services sector, which has telecoms–a classic defensive industry–with such players as AT&T and Verizon, can also be added to this list. Its share of the S&P 500 is 11% and its share of the RSP is 4.48%. True, Communication Services is a newly formed sector that does not yet have clear patterns of behavior, so its impact on the portfolio remains questionable.

Historical Dynamics of Sectors

To make a sectoral breakdown that leverages the strengths of both approaches, let’s turn to history.

If we look at the dynamics of the various spheres of the economy, we see that each sector has its own life cycle. Those segments that were at the core of the economy 200 years ago have aged and lost their relevance over time. For example, in the second half of the 19th century, the railroad sector dominated, reaching a weight of 60 percent of the entire stock market. The railroads were growing rapidly, and the future was behind them. Today it is only a minor industry in the Industrials sector.

One way or another, this was the trend during the second techno-economy. Since the 18th century, since the first industrial revolution, mankind has gone through five technological cycles, and now we are entering the active phase of the sixth.

What was characteristic of the different technoworks

TechnowareResourceKey FactorDirections
The First, 1770-1830Water powerTextile machinesTextiles
The Second, 1830-1880Steam and coalSteam engineTransportation, ferrous metallurgy
The Third, 1880-1930ElectricityElectric motorMechanical engineering, electrical engineering
The Fourth, 1930-1970HydrocarbonsPetrochemicalsOil refining, polymers, non-ferrous metallurgy, automotive industry
Fifth, 1970-2010Atomic energyMicrocircuitsElectronics, IT, telecom, aerospace
Sixth, since 2010Green EnergyArtificial IntelligenceNano-, bio-, cell-, and gene technology, robotics, 3D printing

The last line of the table is predictive: we are just entering the active phase of the new way of life. In a few decades, the world will already be different, and some areas of activity will have receded into the background.

When planning a portfolio for several decades, it is important to look ahead, relying on sectors that will not lose relevance.

Sector dynamics over the last 200 years. Source: Visual Capitalist

The course towards the new technological mode can be seen by studying the changes in sectoral shares in the S&P 500 Index over the last business cycle.

In the table below, I have marked in red the sectors that have lost weight in the index since 2009. These are mainly raw materials and industrial segments, as well as those that provide low value-added products.

Oil and gas has almost completely collapsed during this time. However, this is a specific market, living according to its own laws, and in the medium term it is possible to see its rebound. Anyway, globally, the trend for decarbonization in the sixth technoo clude has been established.

How the share of sectors in the S&P 500 has changed over 11 years

Sector20092020
IT18%30,3%
Health Care15,1%15,2%
Energy13%2,4%
Consumer Staples12,8%8,2%
Financials10,8%13,8%
Industrials9,7%8%
Consumer Discretionary8,9%11,9%
Utilities4,3%3,5%
Materials3,4%2,4%

Note: The sectoral structure of the index has changed over the past decade with the addition of Real Estate in 2015 and Communication Services in 2018. To account for this, the following adjustments have been made to the 2020 column:

  1. Added to the weight of the technology sector is the capitalization of Google and Facebook, which have been in Communication Services since 2018.
  2. Added to the financial sector is 3% – the weight of the Real Estate sector.
  3. Added to the Consumer Discretionary cyclical sector is the weight of the media companies Disney, Comcast, and Netflix, which are now under Communication Services.

The sectors that showed positive dynamics, i.e. whose share increased, are marked in green in the table. The weight of the IT sector has almost doubled. This was one of the reasons why in 2018 there was a structural reorganization and some large companies moved to Communication Services, which became more technological due to this.

Separately, we would like to emphasize that past results do not guarantee the continuation of a trend. But we use historical analysis to identify general trends and to be able to plan the portfolio for the strategic future.

Let’s draw a line in between here:

  1. In investment planning, it is important to consider the sectoral structure of the portfolio. This will largely determine its vector of development.
  2. The strategic portfolio needs an increased share of promising sectors: IT, Health Care, Financials, Consumer Discretionary (contains Amazon). They remain relevant in the sixth techno-cloud, have a reserve for the future and often have high margins.
  3. We should add Communication Services to the same row. There is not enough historical data on it yet, but it includes the up-and-coming Media industry with megacorporations Google and Facebook.
  4. The sector breakdown of the S&P 500 Index better meets our criteria than the equilibrium ETF RSP.

Sector ETFs

Now we can proceed from two theses:

  1. An equilibrium portfolio consisting of large-cap stocks significantly outperforms the classic S&P 500 over the long haul, but has increased volatility.
  2. The sector division of the S&P 500 suits us better in terms of technology.

This knowledge can be combined to increase the efficiency of your portfolio. Let’s apply the equilibrium approach to each individual sector, which is a good thing – there are ETFs on the market. And let’s see if it works. After all, every sector has peculiarities – and somewhere the equilibrium approach can be detrimental.

For comparison, we will use the equilibrium sector ETFs from Invesco and the capitalization-weighted ETFs from Vanguard.

Equilibrium and capitalization-weighted sector ETFs

SectorEquilibrium ETF by InvescoCapitalization-weighted by Vanguard
ITTechnology ETF (RYT)Information Technology ETF (VGT)
Health CareHealth Care ETF (RYH)Health Care ETF (VHT)
Financial ServicesFinancial Services ETF (RYF)Financials ETF (VFH)
Consumer DiscretionaryConsumer Discretionary ETF (RCD)Consumer Discretionary ETF (VCR)
Consumer StaplesConsumer Staples ETF (RHS)Consumer Staples ETF (VDC)
IndustrialsIndustrials ETF (RGI)Industrials ETF (VIS)
EnergyEnergy ETF (RYE)Energy ETF (VDE)
UtilitiesUtilities ETF (RYU)Utilities ETF (VPU)
MaterialsMaterials ETF (RTM)Materials ETF (VAW)

We are not considering Real Estate and Communication Services because the equilibrium ETFs from Invesco on them came out in September 2015 and December 2018, respectively – too short a history for analysis.

Let’s compare two sets of ETFs on the maximum available interval – 13 years. The data are given without taking into account reinvestment of dividends. The funds that performed better than their opponents are marked in color.

Comparison of two ETFs over 13 years

SectorEqual weight, % per yearOn capitalization, % per year
IT (RYT and VGT)11,5713,8
Health Care (RYH and VHT)12,3411,37
Financials (RYF and VFH)2,091,13
Cons. Discretionary (RCD and VCR)6,1110,27
Cons. Staples (RHS and VDC)10,099,15
Industrials (RGI and VIS)8,236,94
Energy (RYE and VDE)−2,76−1,6
Utilities (RYU and VPU)7,497,66
Materials (RTM and VAW)6,956,05

The equilibrium approach works better with Health Care, Financials, Consumer Staples, Industrials, Materials.

Somewhere the difference between the equilibrium and capitalization-weighted sectors is insignificant, like Utilities and Materials, in other cases it is more than 1% of the annual average.

In the case of the IT and Consumer Discretionary sectors, weighted by capitalization, I believe they were pulled forward by mega-corporations with large shares: Microsoft, Apple, Amazon.

As for Energy, it showed the strongest drop of any sector since the beginning of 2020: 26.3%. Unsurprisingly, the equilibrium portfolio, which is more volatile by nature, had a stronger drawdown in the moment.

Creating an optimized portfolio

To do this, we will start from the sectoral structure of the S&P 500, which suits us, but apply the equilibrium methodology to each sector where it yields results.

To test the effectiveness of this approach, let’s take the sectoral proportions of the S&P 500 as of 2009, which I cited above. Give the missing 4% to the Telecommunications industry, which at the time was an independent sector. We do this through the iShares Telecommunications ETF (IYZ).

Let’s compile the first portfolio, which closely replicates the structure of the S&P 500 and is weighted by capitalization. We will need it to compare the results. It should be noted that the addition of 4% Telecommunications has slightly changed the dynamics of the portfolio, as a result it slightly outperforms the S&P 500.

Portfolio structure weighted by capitalization

SectorETF% в 2009
ITVGT18%
Health CareVHT15,1%
EnergyVDE13%
Consumer StaplesVDC12,8%
FinancialsVFH10,8%
IndustrialsVIS9,7%
Consumer DiscretionaryVCR8,9%
UtilitiesVPU4,3%
TelecommunicationsIYZ (iShares)4%
MaterialsVAW3,4%

Now we compile our optimized portfolio. The sector proportions remain the same, only we use an equilibrium ETF for Health Care, Financials, Consumer Staples, Industrials, Materials. I’ve highlighted the changes in color.

Replaced some of the ETFs with equilibrium

SectorETF% в 2009
ITVGT18%
Health CareRYH15,1%
EnergyVDE13%
Consumer StaplesRHS12,8%
FinancialsRYF10,8%
IndustrialsRGI9,7%
Consumer DiscretionaryVCR8,9%
UtilitiesVPU4,3%
TelecommunicationsIYZ (iShares)4%
MaterialsRTM3,4%

Here’s what would have happened if we had invested $10,000 each in two portfolios in January 2009: one close to the S&P 500 and one optimized. The calculation is given without reinvesting dividends or the effects of inflation. Also for comparison, let’s add the equilibrium ETF RSP index, which grows well over 10 years, but whose volatility we weren’t happy with.

Comparison of the S&P 500, the equilibrium index and the optimized approach

PortfolioBottom linePer yearBest yearWorst YearVolatility
Optimized portfolio48 648 $14,86%38,22%−5,9%15,14%
S&P 500, by capitalization44 885 $14,06%33,47%−4,21%14,98%
ETF RSP, equilibrium43 579 $13,76%44,64%−12,08%17,14%

The optimized portfolio yielded $3,763 more than the copying S&P 500. Simply replacing the five sectors in question with their equilibrium counterparts gave us a 0.8% average annual gain.

As you can see from the charts, the optimized portfolio is a consensus between the normal and equilibrium indices. It gives all the advantages of the latter in a rising market and behaves similarly to the S&P 500 in a falling market.

Remember

  1. The principle of equal share weighting beats the index over a distance of 10 years or more, and this is true for large-cap companies. For medium- and small-cap companies, it does not justify itself.
  2. When investing through ETFs, you have to consider the higher maintenance cost of equilibrium funds.
  3. When strategically planning a portfolio, you need to focus on industries and companies that fit into the sixth technological mode, and not hold large shares of fading sectors. The S&P 500 has a better sector structure in this regard.
  4. Each sector has its own peculiarities. The equilibrium approach does not work for all sectors. Applying this approach to Health Care, Financials, Consumer Staples, Industrials, and Materials gave us an average annual gain of 0.8%.
  5. The optimized portfolio is derived from the sector structure of the S&P 500, taking advantage of an equilibrium strategy within certain sectors. Thus, we find a balance in the portfolio for growth rates, volatility, and the proportion of mid-cap companies.
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