Inflation Is a Tailwind for an Equal-Weight Index

Equal-weight strategies such as the Invesco S&P 500® Equal Weight ETF (RSP B+), which tracks the S&P 500 Equal Weight Index, are favored for their diversification benefits, outperformance, and tilt towards value, but many investors are unaware that the increased exposure to smaller companies heightens volatility.

The S&P 500 Equal Weight Index has historically demonstrated about 15% more volatility than the market cap-weighted S&P 500 and has a down capture above one; however, challenging economic environments can actually act as a tailwind for the methodology.

“[The S&P Equal Weight Index] tends to have a down capture above one,” Nick Kalivas, head of factor and core equity product strategy for Invesco, said in an interview with S&P Dow Jones Indices at Exchange: An ETF Experience. “However, in the current market where we’ve seen a lot of volatility, the down capture has actually been about 50%. I think a lot of that has to do with the fact that the correction that has occurred is happening in those big names that really dominate the cap weighted S&P 500.”

Kalivas said that in times of inflation, equal-weight indexes tend to have a tailwind and tend to generate outperformance. 

“Size and value have historically enjoyed periods of reflation in the economy,” Kalivas said. “If we look at the current rise in inflation, which kind of started in May of 2020 just as the pandemic kind of started to ebb, and look to where it is today, we’ve seen a big increase in inflation and equal weight indices have generated about 300 basis points of excess return relative to cap weighted.”

Equal weighting tilts the strategy toward smaller value companies that over time have historically outperformed larger stocks. The equal-weighting methodology also builds in an anti-reversal effect. At the time of rebalance, the fund will sell relative winners and buy relative losers.

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