Index investing is killing the Australian share market. That’s a big unsupported claim, and I am not about to prosecute the case. But I do want to highlight some of the issues with passive index tracking exchange traded funds (ETFs) and compare those following market capitalisation weighted indices to ETFs that track equally weighted indices.
Market capitalisation indices include the S&P/ASX 200, the A200 and the S&P/ASX 300. The bigger the company’s market capitalisation, the greater the weight it has in the index. So, Australia’s largest company by market cap, BHP, has a weighting of approximately 9.6% of the S&P/ASX 200. Strike Energy (STX), the smallest company in the index, has a weighting of just 0.03%.
On the other hand, equally weighted indices treat all stocks the same. So, an equally weighted index of the top 200 would see BHP and Strike Energy both weighted (on balancing) at around 0.5%. Compared to a market cap weighted index, such as the S&P/ASX 200, a massive underweight for BHP and a massive overweight for Strike Energy.
An issue for market cap indices is that they lead followers (for example ETFs) by their actions to accentuate the direction of price movement. As a stock rises relative to the rest of the market, its market weighting increases. So, an ETF has to buy more of the stock as the price rises to maintain its market weight exposure. Conversely, as a stock falls relative to the market, an ETF needs to keep selling its holding in the stock.
There is no “human” sitting at the wheels of the ETF in charge of buying or selling. They are run by machines, on auto pilot, and because they typically rebalance every day, slaves to the market. Absurdly, the higher the price of a stock, the more ETFs need to buy, and the lower the price, the more ETFs need to sell.
“‘Higher” and “lower” are of course used in a relative sense as changing stock weights are about outperformance or underperformance compared to the overall market. But taking the scenario to the ultimate outcome or logical conclusion, we will end up with a market of just one single stock.
Of course, capping market weights (with say a cap of 5%) would stop any one stock dominating.
Considering the benchmark S&P/ASX 200 index, the top 10 stocks now represent 48.7% of the index. This is up from 43.4% in December 2021. While there are also other factors in play, ETF investing is one of the forces driving increasing concentration.
In the USA, the scenario is even worse. The top 10 stocks in the S&P 500 now weight at 35.8% at the end of June, up from around 29% at the end of 2021. While this is mainly being driven by the AI boom and the “big 7”, the big US ETFs need to keep buying these stocks the more they outperform. If NVDIA keeps going higher, the ETFs will keep buying.
Concentration risk is becoming a major issue for equity markets.
How do equally weighted ETFs stack up?
MarketVector compiles the MVIS Australian Equal Weight Index. It includes the largest and most liquid companies on the ASX. A rules-based methodology focussing on liquidity is applied, with a minimum of 25 holdings. The holdings are equally weighted.
Currently, there are 74 companies that qualify for the index, each weighted (when balanced) at around 1.4%. The index also has rules around the domicile of assets and revenue, which means companies such as Resmed, Amcor and Xero miss out.
Comparing the benchmark S&P/ASX 200 index to the MVIS Australian Equal Weight index, the sector weights are quite different as the following table shows. It is materially underweight financials and healthcare, and materially overweight industrials.
Sector Weights – S&P/ASX 200 vs MVIS Equal Weight
On a performance basis, the MVIS index has materially outperformed the S&P/ASX 200 over 10 years (9.53% pa vs 8.06% pa) and marginally over 3 years. It has underperformed over the last 12 months and marginally over the last 5 years.
Annualised Total Returns to 30/6/24 – S&P/ASX 200 vs MVIS Equal Weight
On a calendar year basis, it has outperformed in 7 of the last 10 years and underperformed in 3 of those years (including so far in 2024).
Calendar Year Total Returns – S&P/ASX 200 vs MVIS Equal Weight
I find the performance of the Australian equally weighted index to be quite surprising. I dismissed equal weight indices (and their ETFs) when they were first introduced, but the performance speaks for itself. Arguably, they are a little more volatile because of the amplified gains from smaller stocks.
Longer term, equally weighted indices are expected to be more volatile but have higher returns due to greater exposure to smaller, potentially higher growth companies.
In the Australian market’s case, equally weighted indices will tend to have marginally lower income returns because in many cases, larger cap stocks (e.g. banks, Telstra etc) pay higher dividends. Over the 5 years to 30/6/24, the distribution return from the benchmark S&P/ASX 200 index is 4.01% pa whereas the distribution return from MVIS is 3.76% pa.
VanEck’s Australian Equal Weight ETF (MVW)
Under the ASX code MVW, VanEck issues the VanEck Australian Equal Weight ETF. It tracks the MarketVector Australia Equal Weight Index described above.
With more than $2.0bn in funds, liquidity in this ETF is quite good. The management fee at 0.35% pa is on the high side, particularly when compared to STW, IOZ or VAS, each of which are charging between 0.05% pa and 0.07%pa.
MVW could suit those who want broad market exposure but think the major banks (in particular) and some of the other large cap stocks are expensive, and market performance is going to be driven by mid-caps and stocks outside the top 10.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
