Apple and the Pitfalls of Cap Weighting

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[dropcap]O[/dropcap]ne look at Apple’s (AAPL) 10-year price graph can elicit vertigo – growth has been exponential. With a market cap now over $550 billion, it has become the largest company in the world and a darling for individual and institutional investors alike. At $400 billion, Exxon Mobil (XOM) is a distant, and less exciting, second. Such valuations haven’t existed since the technology boom over a decade ago. Whether the stock continues its meteoric rise or plummets back to earth is up for debate. The latter, however, would have a much wider impact than most anticipate. Owners of Apple stock aren’t the only ones with value at risk – even passive mutual fund and ETF investors would experience meaningful pain.

Unintended Bets

The foundation of prudent investing rests in diversification. Even amateurs know this. It’s one of the primary reasons mutual funds and ETFs were founded in the first place. And for the most part this is how they’re used. When you buy an S&P 500 Index ETF, you’re buying the “market” and automatically diversifying your portfolio, right? Not entirely. The reason is market capitalization weighting. In other words, the position weights are based proportionally on each stock’s market capitalization – the larger the market cap, the larger the weight.

This creates issues when a single stock (e.g. Apple) rises far beyond the rest. Consider the top ten most popular domestic equity ETFs by assets, as ranked by ETFdb. The average weight of Apple is over 7.8%, according to Morningstar.com. And if you consider the two technology-focused ETFs your Apple exposure is closer to 17% (both figures exclude ETFs incapable of holding Apple such as small cap focused, value-based, etc.). Industry experts would agree that single stock exposure over 7% is a concentrated bet – one that can significantly increase portfolio risk. But most don’t realize this when purchasing passive index funds and ETFs. These vehicles are commonly perceived as diversified.

Flaws of Cap Weighting

Apple’s rise has made it the single largest driver of returns in many domestic equity ETFs and index funds. But the risk of cap weighting goes beyond single stock exposure. Consider economic sectors. As investors gravitate towards “hot” areas of the market, they inherently become larger weights in the underlying index. For instance, if you purchased the S&P 500 in 1999 you would have held close to 30% of your portfolio in technology stocks. Doing the same in 2006 would leave almost a quarter in financials. Those are significant bets. And we all know what happened in subsequent years. Both sectors experienced precipitous price declines of approximately 80%. So despite buying a “diversified” index fund, many investors suffered significant portfolio losses.

This is the primary flaw of cap weighting. Just because a stock or sector is larger, it doesn’t mean it will perform better. But that’s exactly the bet investors make when they purchase cap weighted ETFs and index funds. Let’s look at two stocks in the same economic industry: Wal-Mart (WMT) and Whole Foods (WFM). At the March 2009 bottom Wal-Mart had a market cap of around $190 billion, while Whole Foods’ sat around $2 billion. An owner of a cap weighted index would have almost 100 times more exposure to Wal-Mart. Where are they now? Since the March bottom Wal-Mart is up approximately 41% and Whole Foods is up over 600%.

Moving Away From Cap Weighting

Investing in cap-weighted ETFs and index funds inherently places more emphasis on larger companies and sectors. One way to compensate for this bias is through equal weighting. This involves assigning equal portfolio weights to different market categories and stocks. In other words, assign the same weight across economic sectors, sizes and styles, as well as the underlying stocks. Doing this helps mitigate the impact of large implosions like Technology in 2000 and Financials in 2008. It would also help reduce concentrated stock bets. So if Apple falls on its face, the impact to your portfolio would be limited. Moreover, research shows that over time equal weighting has achieved significantly greater returns than cap weighting.

Equal weighting is best achieved through a sampling of individual stocks. This provides greater control and can be cheaper than purchasing equal weighted ETFs and funds. Using individual stocks does involve more maintenance (re-balancing) and is difficult to accomplish with small investment amounts. Guggenheim investments, however, offers a selection of domestic equal weighted sector ETFs. Most carry annual expense ratios of around 0.50%. These would eliminate the need to re-balance individual securities, but the investor would still be responsible for keeping sector weights in line. The primary drawback is low trading volumes.

Final Thought

Investors beware. Just because you own index funds and ETFs it doesn’t mean you’re well diversified. It’s worth taking a closer look at the underlying holdings to see if you’re taking any unintended stock or sector bets.

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Brendan Erne, CFA
Brendan Erne serves as the Portfolio Management Team Leader with Personal Capital Advisors. He has over 15 years of industry experience, spanning almost all levels of the investment process, including several years at Fisher Investments as an equity analyst covering the Technology and Telecommunications sectors. He also co-managed a large cap growth portfolio and co-authored Fisher Investments on Technology, published by John Wiley & Sons. Brendan is a CFA charterholder.
Brendan Erne, CFA

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