Market cap weighting can result in unintended risks. Even if an investor thought they were purchasing the market through an S&P 500 index fund, by definition they would be overweight to the largest stocks. But just because they are the largest stocks it doesn’t mean they will perform the best. Cap weighting can also result in sector risks. An S&P 500 index fund in 1999 would have significant exposure to technology stocks, while the same fund in 2006 would have a large weight in financials. Both sectors experienced significant downturns in the subsequent years, subjecting “passive index” investors to large losses. Equal weighting size and sectors can help mitigate these risks.
Even with the Standard & Poor’s 500 Index down 19 percent since the bursting of the technology bubble in 2000, it’s been no lost decade for stocks. The benchmark gauge for American common equity climbed 66 percent from March 24, 2000, through Dec. 2, after stripping out adjustments for market value, which gives equal credit to Exxon Mobil Corp. (XOM), whose shares are worth $382.5 billion, and Monster Worldwide Inc. (MWW), at $945.6 million. That’s little help for most investors, whose returns reflect the capitalization-weighted index, says Cliff Asness at AQR Capital Management LLC. Gains in the S&P 500 Equal Weighted Index through the dot-com tumble, the Sept. 11 attacks, the real-estate collapse and the worst financial crisis since the Great Depression show the resilience of U.S. companies that are forecast to report record earnings this year even as Europe’s debt crisis threatens growth again. Declines in the S&P 500’s biggest members have left them cheaper (OEX) compared with the full index than 89 percent of the time since 2000, according to data compiled by Bloomberg.
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