Investors are pouring money into this modified S&P 500 stock-market strategy

Investors love index funds because of their low expenses and their tendency to perform well when compared with actively managed funds over long periods. But success can heighten concentration risk, even when a fund has the magic “500” number as part of its name.

The SPDR S&P 500 ETF Trust SPY was established in 1993. It was the first exchange-traded fund to track the benchmark S&P 500 SPX. It now has $412.5 billion in assets under management. It attempts to mirror the index’s performance by holding all 500 stocks with the same market-capitalization weighting. What this means is that SPY’s top five holdings (Apple Inc. AAPL, Microsoft Corp. MSFT,Amazon.com Inc. AMZN, Nvidia Corp. NVDA and two common-share classes of Alphabet Inc. GOOGLGOOG ) make up 24% of the portfolio, according to data provided by FactSet. The top 10 holdings (again with two Alphabet share classes, for a total of 11 stocks) make up 31.6% of SPY’s portolio.

According to Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management, this concentration for the top 10 companies in the S&P 500 is higher than the “25% during the 1999-2000 tech bubble and an average of 20% over the past 35 years.”

“This means that money deployed into the market-cap-weighted S&P 500 is increasingly a wager on the health of just a few companies — with the fundamentals of the other 490 carrying less weight,” she wrote on May 24.

And now, according to Nick Kalivas, head of factor and core product strategy for ETFs and indexes at Invesco, “people are thinking about the narrow leadership.”

It turns out that over the past five weeks, from the close on May 19 through the close on June 28, $4.8 billion in new money flowed into the Invesco S&P 500 Equal Weight ETF RSP. That was 14.9% of the fund’s assets under management on May 19. Here’s how those numbers compare with the inflows for SPY and the SPDR Portfolio S&P 500 ETF SPLG, which, like SPY, is cap-weighted:

We included SPLG along with SPY because SPLG is a newer fund (launched in November 2005) with lower annual expenses of only 0.03% of assets under management. This and other technical differences with SPY are meant to help it track the S&P 500 even better than SPY has. SPY’s expense ratio is 0.095%. RSP’s expense ratio is 0.20%.

The money inflows in the chart are actual “new money” coming into the ETFs, resulting in the creation of new shares. The inflows don’t reflect stock price changes within the portfolios.

Conversely, when there is a high enough net inflow of outflow from an ETF, it will redeem shares, to keep its own share price close to its net asset value (NAV). (For any mutual fund or ETF, the NAV is the value of a fund’s investments at the market close divided by the number of shares. ETF managers aim to keep the publicly traded share price as close as possible to the NAV.)

During an interview, Kalivas pointed out that the Invesco S&P 500 Equal Weight ETF is “15% underweight” in the information technology sector when compared with the cap-weighted index, and 4.5% underweight in communications services, the sector that includes Alphabet Inc. and Meta Platforms Inc. META (the seventh largest holding of SPY).

The Invesco S&P 500 Equal Weight ETF is 7% overweight in the industrial sector, relative to the cap-weighted index, Kalivas said, adding that RSP is overweight 3.5% to real estate, 3% overweight to materials and utilities, 1.7% overweight to financials, with the other sectors “a wash.”

Kalivas said the equal-weighted approach “tends to be more volatile” than the cap-weighted approach because of greater exposure to smaller companies. But you can see above that despite this year’s tech rally the equal-weighted approach is on top for three years. This is because RSP declined 11.6% in 2022, while the S&P 500 fell 18.1% as its technology sector dropped 28.2% (all with dividends reinvested).

Kalivas added that “when investors want core anchor exposure, they realize that equal-weighted is doing that,” and that they “probably have something else that focuses on growth.”

He also said that RSP’s periodic rebalancing to an equal weighting has helped feed its index-beating 20-year performance because the fund “needs to sell high and buy low.”

“This is especially salient in such a narrow market rally, where are few stocks are driving the majority of the returns, creating a significant outperformance between cap-weighted and equal-weighted S&P 500. “