Under the Hood | Equal Weight v Market Cap Weight: What’s better?

Bryce: [00:00:31] Welcome to Get Started Investing a podcast where we attempt to answer the most common money and investing questions from the community to help us all become better investors. Now, if you're joining us for the very first time, welcome and massive congrats for getting on the investing journey. We strongly recommend that you scroll up and started episode number one while we are licensed. Were not aware of your personal circumstances. All information on this show is for education and entertainment purposes. Any advice is general advice only. But with that said, my name is Bryce and as always, I'm joined by my equity buddy, Ren. 

Alec: [00:01:02] How are you? I'm very good. Bryce. Excited for this episode. Been loving this whole series we're getting towards the end, which is sad, but one thing that I remember are speaking of the early days of equity mates when we were still trying to get our head around this whole world of investing. We heard about equal weight ETFs and it was something that really piqued our interest and there wasn't a lot in Australia at the time. Good news is ETF providers must have heard us because we're starting to say more and more equal weight ETFs come to market. So as investors, it's important that we understand what's a market cap weighted ETF, what's an equal weighted ETF, and when would we invest in either of them? That's what we're going to answer in today's episode.

Bryce: [00:01:49] That's it. And we are loving hearing questions from the equity markets community in response to this series. We went out and asked for questions and have built this episode around the questions that were coming in and we and we've got one specifically around this topic. 

EM Community: [00:02:03] Hey, equity mates. I've heard you guys talk about this before, but I'm always forgetting and a bit confused. What exactly is the difference between an ETF that talks about equal weight and market cap? And like, should I ever be looking at one over the other?

Bryce: [00:02:20] And a massive thank you to Global X for supporting the Under the Hood series and for providing access to some of their experts to help us unpack these questions. And we're bringing back to the studio. Jessica Leung. Jessica, welcome. 

Jessica: [00:02:34] Thanks for having me back, guys.

Bryce: [00:02:35] So Jess is a portfolio manager at Global X who are later a leading player in the ETF industry with over a million clients in 95 countries through targeted products and an industry leading research team. So today, equal weight market weight? I can't wait. Thank you. I guess we got to start with some definitions. 

Alec: [00:03:01] Well, let's start with the ETF that we're looking at today. 

Bryce: [00:03:03] Sure. Global X, FAANG Plus ETF, the ticker is FANG, Ticker is F A N G, so you can follow along at home. That's what we're going to go under the hood for. And you will find out why in a moment. 

Alec: [00:03:16] Well, now let's get to your definitions. 

Bryce: [00:03:18] Let's start with definitions. 

Jessica: [00:03:21] I can't wait. 

Bryce: [00:03:23] Well, five how many times can we get it in? Let's start with the most common, which would be market cap weights, which is probably how most of us who invest in ETFs, that's the type of ETF that we'd be investing in. So what is market cap weighting? 

Jessica: [00:03:36] So market cap weighting is when a stock or its percentage is proportional to the market value on the share market. So that just means shares outstanding times the price. 

Alec: [00:03:47] So if Apple is double the size of Facebook or Meta now, then the ETF will have double the amount of Apple than it does meta. 

Jessica: [00:03:57] Correc. 

Alec: [00:03:59] Makes sense. 

Bryce: [00:04:00] Sweet. So that's pretty Straightforward. 

Alec: [00:04:02] And for people who are used to the market indexes, the ASX 200, the S&P 500 in the US, Footsie 100 in the UK, they're all market cap weighted.

Jessica: [00:04:14] Yes, that's right.

Bryce: [00:04:15] And so when you look at top ten holdings of a market cap weighted, it's in order of. 

Jessica: [00:04:19] The largest to smallest. 

Bryce: [00:04:21] Just the smallest. The company that has the largest market cap through to the company that has the smallest cap. A classic example of this is the S&P 500, the 500 largest companies by market cap. 

Alec: [00:04:34] Didn't I say that? 

Bryce: [00:04:34] Did You? Doubling down. On it.

Alec: [00:04:39] So that's market cap weighted. Equal weighted. 

Jessica: [00:04:42] Yeah. So equal weight means all stocks have equal weight. So, for example, FAANG has ten stocks, so each stock is 10%. So you kind of think about it as, you know, if the whole index ETF was up high, the market cap weighting means that each stock its slice is just proportional to its size, whereas then equal weight is each slice has the same size. 

Alec: [00:05:03] So in a market cap weighted ASX 200 ETF, BHP is the biggest company in Australia and it's about 11%, whereas in an equal weight ASX 200 ETF, all 200 companies would get the same amount, so they would each have 0.5%. 

Jessica: [00:05:22] Yeah. So one divided by 200. 

Bryce: [00:05:27] Wow. Just is good. So the next question that comes to mind Jess, is what, what's the difference between the two from a performance point of view? Is one better than the other? If I've got Ren's example of an equal weight ASX 200 and an A market weight, how should I be thinking about the two?

Jessica: [00:05:45] Yeah. So going back to I guess the example of the S&P ASX 200. So can you guys take a guess? So this is as of the end of March, what's the cumulative weight of the largest ten names in the index. 

Bryce: [00:05:59] That's the ASX 200. 

Jessica: [00:06:00] Yeah. So you mentioned BHP was 11%. So now what about. 

Bryce: [00:06:04] I'm going to guess 

Alec: [00:06:05] CBA, CSL.

Bryce: [00:06:07] For the top ten. Did you say.

Jessica: [00:06:09] Yeah, top ten in total. 

Bryce: [00:06:10] So like 68%.

Alec: [00:06:11] Oh okay. Yeah, I was going to go high but I feel almost 67% and it's closest to is. 

Jessica: [00:06:19] Well unfortunately you guys both are a bit off is actually 47%. But that's still a lot. That's still close to half of the index. In your ten names out of the whole 200.

Alec: [00:06:30] Here's a question now. I don't know if you've got this data handy, so we might need to do a bit of research. What about the bottom ten names.

Jessica: [00:06:37] And less than 1%? 

Alec: [00:06:39] Easily less than 1%. They're actually so small that I need another decimal place on the website I'm looking at because they're all listed at 0.0%. Yeah.

Jessica: [00:06:50] Yeah. So that brings a good point. So although if you do hold a fund that tracks the S&P ASX 200 index, so you may be diversified in terms of the number of names, So 200 names, but is your exposure really diversified then? Right. So that's why I guess one way to address this is actually exclude them. So timing actually works out well for this because we're just launching a new fund, so it's OZXX, So that's the ticker or it's a global X Australia X Financials X Resources ETF. So one way to just exclude your largest names or your larger sectors, so that's being financials and resources or you can go equal weight. 

Bryce: [00:07:29] Right. 

Alec: [00:07:30] So in equal weight, BHP number one and Laker resources at number 200 have exactly the same amount of impact on your return. And so I guess the question is historically has a market cap weighted index or an equal weight index done better, I guess, or does it just depend on the market? 

Jessica: [00:07:48] So here's starkly if we now move on to the S&P 500. So like you said, the 500 largest names listed in the US equate has historically outperformed. So let's just look at calendar year 2022 equate outperformed the market cap by 6.3%.

Bryce: [00:08:06] I was just going to say it's because equal weight, equal voice is how I think about it.

Jessica: [00:08:11] Like equal representation. 

Bryce: [00:08:14] Equal Representation like you're giving the 200th company the same chance to contribute to the performance of the ETF. Then you are the number one company in an equal weight. 

Alec: [00:08:23] To build it even further, the smaller companies that are forcing their way into these indexes they have to grow into and they're in a bit more of a growth phase. I punch middle. Yeah, well, they like mid-cap stocks that are growing into large cap stocks. And so just historically, they've grown faster than large cap stocks which grow at, you know, the rate of immigration or the rate of inflation or whatever the market's doing. You know, CBA consistent, not spectacular. 

Bryce: [00:08:53] Yeah, or it's like in this S&P 500 example, the top holdings were tech which got. Smashed. But you might find that there are 100 other companies in there contributing that weren't in tech and weren't smashed as much, which is hence why you're getting over that. Yeah.

Jessica: [00:09:07] Well, it sounds like you guys are the experts. Am I needed for. Well, you guys are going have got the understanding down pretty well. 

Alec: [00:09:14] You know, as we were saying, we've been calling for people indexes for years. The flip side, we should say, because we're like we are. It sounds like we're making the case for equal weight, but we should say that the past, what, 15 years in America is a classic example where market cap weights have been really strong because it's been Apple, Microsoft, Amazon, the biggest companies that have also been really fast growing. 

Jessica: [00:09:38] So well, actually, yeah. Even if we look back 20 years, the equal weight has actually outperformed go on annualised basis, I think close to 1% per year. 

Bryce: [00:09:50] Oh, nice. That makes a difference over 40 years. 

Jessica: [00:09:52] Yeah. So compounding definitely makes a huge difference. 

Bryce: [00:09:55] Yeah. So, why are there not as many equal weights available as there are market cap? Is that just because index providers? 

Jessica: [00:10:04] Yeah, I think it's demanding political. 

Alec: [00:10:06] You're going to say that maybe. 

Jessica: [00:10:07] People just aren't aware of equal weight or they don't understand. Maybe they just think when they buy the ASX 200 that that is equal weight and not market cap weight. 

Alec: [00:10:15] Well now that they are aware, just expect lots of contacts from the equity markets community asking you guys to create more equal equity. 

Jessica: [00:10:22] Yeah, but let's just recap. So let's actually go to the reasons why an equal weight tends to outperform a market cap weighting historically. So like you guys mentioned, it's actually because of those small cap tilts. So smaller companies tend to outperform large companies over time. So, you know, your larger companies are more well-established. That is just treading along very steadily while your small ones, you know, there's a larger chance for them to do very well. So in an equal cap waning, it's more so that success over the long term is determined by whether you are exposed to those small numbers of names that do really well. So equal weight means equally exposed. . 

Alec: [00:11:00] So let's turn to an equal weight ETF in the global X portfolio. In the global X range of products, the FAANG plus ETF. And before we even talk about what's in the ETF, how do we know it is equal weighted? If I hadn't just said it in the introduction that if we just came across and we were researching it, how would we know that it was equal weighted or or if it was market cap weighted? 

Jessica: [00:11:25] Yeah. So ETFs, issuers website is always your best friend and tool. So in this case it will be globalxetfs.com.au, just hop on and then there will be other documents such as a fact sheet or the PDS and it should be all covered in there. 

Bryce: [00:11:40] So full transparency. I do own FAANG plus, but Ren, when we now go and look at the website, it is a little confusing because the percentages aren't all the same. We've got I am day at 10.5%, apple at 10%, Snowflake at 9.5%. And the list goes on. But it's not an equal representation of 10% across the board. 

Alec: [00:12:01] Well, Bryce, correct me if I'm wrong, but 9.5% is not equal to 10.5%. 

Bryce: [00:12:06] You damn. Right.

Alec: [00:12:08] So just what's going on here? 

Jessica: [00:12:10] Yeah. So when we mean equity, it means equal weight when we rebalance the fun. So the fun is rebalance every third Friday. So follows mostly, I mean, third Friday, March, June, September and December. So every calendar quarter. Yeah. So follows the same schedule as like your S&P 500, almost bigger indices. 

Alec: [00:12:29] Rough that they make you rebalance on a Friday because I assume there's a lot of work that then happens on that Friday. Like why wouldn't you just rebalance on a Wednesday and give everyone a couple of days to get sorted? 

Jessica: [00:12:39] That's index rebalance. Those are not my favourite days. 

Bryce: [00:12:42] When's the next rebalancing? 

Jessica: [00:12:43] So the next one will be the third Friday, June. 

Bryce: [00:12:46] Nice. I'm going to jump on because it'd be quite satisfying saying in Avon ten across the board. Rebalancing day for us. 

Alec: [00:12:54] Bryce will put it on our social well, that's a commitment. 

Jessica: [00:12:57] I'm sorry to disappoint, but you won't actually ever see it at ten. Oh oh. Very unlikely. Okay, so if I told you that the fund is rebalancing today at 410, when the market closes, every stock needs to be 10%. How would you do it If you needed to rebalance a fund today? 

Alec: [00:13:14] I'd call you up at just. 

Bryce: [00:13:18] Sure it's possible. 

Jessica: [00:13:19] Oh, if I'm putting the trades on for tonight, say, for U.S. markets, I'm not sure which way the markets are going to go. I'm not sure what the stock performance is. So it's really hard to get 10%. Exactly. So that's why we've recently changed the methodology. So two days before the third Friday. So on Wednesday, they actually set at 10% and then they drift. 

Alec: [00:13:41] Right? Okay. So okay, well, that's just dashed all out. [00:13:45][4.5]

Jessica: [00:13:45] I'm sorry. It wasn't satisfying. 

Alec: [00:13:48] So just to put a bow on that, the fact that I am day is at 10.5% and Snowflake is at 9.5% means when you rebalance. They were both at ten. Or thereabouts. But then, since that rebalance, AMD's share price has gone up and snowflakes have gone down, and that's why they've drifted in those direction.

Jessica: [00:14:08] Yeah, that's right. 

Alec: [00:14:09] Makes sense. So with that said, let's go under the hood. We always want to start with the key information. So what is it? Trying to achieve this ETF. Okay. The purpose. And then how is it trying to achieve that with the index attracts? So what are we trying to achieve here? 

Jessica: [00:14:27] So this one investment company is at the leading edge of next gen tech. So your mega disruptors, your innovators. And it does that by tracking the NYSE FAANG plus index. 

Alec: [00:14:38] Nice. Easy. Make sense.

Bryce: [00:14:41] So the fees are 0.35%. And the performance, as we know, tech has done incredibly well over the past few years. The fund has returned 23.6% over the past three years. It hasn't been listed that since inception, Jess. Yeah. 23.6%. And over the last 12 months, it's returned 2.2%. 

Alec: [00:15:03] Has it been a good 12 months?

Bryce: [00:15:04] Hasn't been. It's been a more challenging. Now, the geography. Boy, oh, boy, 99.9% in the U.S.. When I bought it, it had some exposure in other countries. So what's happened? 

Jessica: [00:15:18] So we've actually had a recent index methodology change. So we actually do listen to you guys because I remember a few episodes back are questioning why? Why is Baidu in Fang and not tech and not Tencent? 

Bryce: [00:15:32] Oh yeah. Okay. 

Jessica: [00:15:34] So we've actually reach out to the index provider, giving them some feedback and we've actually changed the index methodology. Yes. So what's actually happened is that now companies are required to be incorporated in the US, right? Okay. Yeah. So that removes your ideas. And GDS ADR is American Depositary receipt. So which just means that other stocks can overseas stocks in the US and the US is global with depositary receipts. That means that Chinese companies like Alibaba, Baidu have since been removed. 

Alec: [00:16:08] Yeah, yeah. Because when we first look at this ETF, there were Chinese companies. But yeah, it was only if they had that product in America. Yeah. 

Bryce: [00:16:18] So US companies are at the leading edge of next gen technology. 

Alec: [00:16:23] Yeah. And it's not just Chinese companies that aren't in it. I think you were saying Bryce ASML, the gone lithography company from the Netherlands is not in there anymore. Absolutely. So that's why you don't just look under the hood once you go to the great point.

Bryce: [00:16:38] Right point. What I Bought has changed and I'm sure I got an email about it. 

Jessica: [00:16:44] Yeah, I'm sure you did. Well, I guess to cover some of the other index changes. So now as often is Fang Plus. So your starting point is going to be your fang. So you are Facebook, Amazon, Apple, Netflix, Microsoft and Google, essentially the Fang Ms. And then to qualify for the other meaningful stocks, they need to be consumer discretionary media and communications or technology names and of course have to be listed on the Nasdaq. 

Alec: [00:17:12] So the other four names are AMD, Nvidia, So two microchip semiconductor companies, Tesla heard of it. 

Bryce: [00:17:23] Heard of it. 

Alec: [00:17:24] And Snowflake which is one you were surprised by. 

Bryce: [00:17:27] Yeah I was but could see it in that. 

Alec: [00:17:31] So Jess, Fang plus where would it fit in someone's portfolio. 

Jessica: [00:17:35] So we think that Fang fits quite well in of course that alliance strategy. So maybe taking a step back, going back to the Nasdaq 100 index or the S&P 500 index, your largest weights by market cap are the names in the FANG Plus ETF and as well their contribution to the stock returns. So if we look at index 100, so you say it returns 20% and then fang plus year to date return is I think 36%. The key contributors to the Nasdaq's 20% is actually from the fang names. So in terms of this one, it's not really about picking the winner, but getting equal representation, you know, to these winners that we know are contributing to performance. And so you want exposure to your disruptive tech and innovating names. So maybe it might sit in your core. And sometimes it's not always about choosing this one or the other. Maybe this one can complement and your call to smooth out returns over a long time. Or you can also be used as a thematic tilt towards megatrends as a satellite. 

Bryce: [00:18:35] Ten stocks all equal weight. So as we said at the top, they all have the same chance of contributing to the performance. So if Apple shoots the lights out, it's not going to well, I mean, it'll contribute just as much as if Tesla shoots the light out, lights out. If snowflake shoots the lights out, you're not just relying on those big heavy hitters making up 60% of the of the of the portfolio. They all have an option. Charity to contribute. So as we set out at the top to understand what equal weight is versus market cap weight. There are equal weight opportunities available as we've discussed this sum coming to market through Global X, but it's definitely something to add to the toolkit. Like there's definitely value in it as we've as we've unpacked that it does outperform for the examples that we gave. I'm not going to we're not going to say that it always outperforms in all instances. 

Alec: [00:19:23] No, we're not going to say that because it's not true. 

Jessica: [00:19:26] And let's just yet clear it up. Equal weight, although it has historically outperformed it, also means it's more risky and more volatile. So not all pluses. There are also risks associated with it as well. 

Bryce: [00:19:37] Good point. Good point. So keep it in mind because, yeah, they're not prolific, but they are out there. And if you're looking to, you know, diversify or have slightly different investment strategies, understanding how equal weight can play a part in your portfolio is certainly important. But yes, thank you so much. It's been an absolute pleasure and thank you to Global X for supporting the Under the Hood series. We are getting close to the end. We've got two more to go and we're really starting to now close out our toolkit of understanding how to actually analyse ETFs when we're building our own ETF portfolio. Global X is a leading player in the ETF industry. They've got a robust platform with over 30 targeted products with a globally trusted reputation with over a 1 million clients in 95 countries, and they're uniquely positioned to identify and analyse disruptive companies with their industry leading research team. And we've been able to shine a light on some of the really disruptive ETFs within their portfolio of products. For more information, head to globalxetfs.com.au to find out or to go under the hood of the products that we've discussed. But Jess, absolute pleasure. Thank you so much. We really appreciate it. 

Jessica: [00:20:43] Thanks for having me. I can't wait to come back again.