Market-cap weighted is the go-to method for calculating equity indices however they have one significant design flaw especially when markets head towards the end of the business cycle.

The tried and tested method is the usual benchmark of active equity managers and where the majority of ETF and index assets flow. However, market-cap weighted indices have a natural bias to the biggest companies in the index by definition and therefore overweight the winners and underweight the losers.

This works very well until markets reverse as investors found out the hard way during the ‘dot com’ bubble in the early 2000s and the Global Financial Crash (GFC) in 2008 when the S&P 500 overweighted technology and financial stocks, respectively.

For example, Japan made up over 40% of the MSCI World in 1989 during its boom years while the tech, media and telecommunications sectors peaked at around 33% of the same index in 2000.

A similar situation is taking place in the current market cycle following the dramatic rise of the FAAMGs over the past decade.

Facebook, Amazon, Apple, Microsoft and Google (Alphabet) now account for 22% of the S&P 500, up from a 16% average in 2019, the biggest concentration by the top five stocks for 40 years, according to S&P Dow Jones Indices data.

Highlighting this, if the FAAMGs dropped 10%, for example, the bottom 100 stocks in the index would need to rise 90% to level out, according to a research note by Goldman Sachs.

Furthermore, the five stocks have been the sole driving force of the S&P 500’s performance this year contributing 9.4% out of 9.7% of the index’s returns, as at 31 August.

As the Goldman Sachs analysts warned: “From a macro perspective, record concentration means the S&P 500 has never been more dependent on the continued strength of its largest constituents or more vulnerable to an idiosyncratic shock to any of these stocks."

Despite this risk, the biggest ETFs on both the European and US markets are S&P 500 ETFs and investors continue to pile into these flagship strategies.

However, there are other options available to investors concerned about the potential concentration risk of a market-cap weighted approach such as equal weighting.

As Nicolas Rabener, founder and CEO of FactorResearch, said: “Market-cap frequently leads to indices like the S&P 500 becoming expensive and makes a strong case for equal-weight indices. 

“There is plenty of research that supports equal-weight over market-cap weight indices over the long-term, although in the most recent decade market-cap weight dominated, which is explained by large and expensive stocks outperforming.”

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While this method has its own issues such as liquidity constraints and higher transaction costs, it gives investors diversification especially at points in the business cycle when they need it the most.

Diversification is considered the only “free lunch” in investing however a market-cap weighted index becomes less diversified the more expensive it becomes meaning investors will feel the impact even more if and when the FAAMGs trade reverses.