Analysts at Goldman Sachs recently published a gloomy 10-year outlook for the S&P 500 (^GSPC -1.11%). According to their forecast, the index will return just 3% annually through 2034, which is far below its annualized returns of 13% over the last 10 years.
The Goldman analysts highlighted two reasons they expect that the benchmark index is due for a dismal decade: elevated valuations and "market concentration that currently ranks near the highest level in 100 years." Investors cannot change the valuations of the stocks that comprise the S&P 500, but they can buy an equal-weight index fund, which sidesteps the concentration problem.
Goldman estimates that an equal-weight S&P 500 index fund will beat the traditional S&P 500 by between 2 percentage points and 8 percentage points annually during the next decade. If we take the midpoint of that forecast and assume an equal-weight index fund will beat the S&P 500 by 5 percentage points annually, such a fund's expected 10-year return would be 116%. Meanwhile, based on the premise of the S&P 500 returning 3% annually, its expected 10-year return would be 34%.
In other words, Goldman Sachs expects an equal-weight S&P 500 index fund to more than triple the return of the traditional S&P 500. That is a compelling reason to at least consider buying shares of the Invesco S&P 500 Equal Weight ETF (RSP -0.68%).
The Invesco S&P 500 Equal Weight ETF
The traditional S&P 500 is weighted by market value, meaning megacap companies like Apple, Nvidia, and Microsoft exert much more influence on its performance than smaller companies. In fact, the "Magnificent Seven" stocks account for around one-third of the index in terms of weighted exposure.
The Invesco S&P 500 Equal Weight ETF provides exposure to the same companies, but it eliminates the concentration "problem" by weighting each stock evenly. I used quotes because not all analysts have an issue with the concentration of the S&P 500. The Magnificent Seven are some of the most fundamentally sound companies in the world. In aggregate, their net profit margin is more than double that of the other 493 companies in the S&P 500.
However, earnings growth across the Magnificent Seven is expected to slow down next year, while growth across the other S&P 500 companies is forecast to accelerate. That may cause valuation multiples to compress across the Magnificent Seven, which would be a serious headwind for the traditional S&P 500.
That said, the Magnificent Seven have accounted for more than one-third of the gains in the S&P 500 in each of the last four years. As a result, the Invesco S&P 500 Equal Weight ETF has posted total returns of just 55% since December 2020, while the traditional S&P 500 has achieved total returns of 72%. If the Magnificent Seven stocks continue to lead the market higher in the coming years, the same pattern will repeat itself.
The last item of consequence is the expense ratio. The Invesco S&P 500 Equal Weight ETF has a middling expense ratio of 0.2%, which means investors will pay $2 annually for every $1,000 invested in the fund. That is higher than most S&P 500 index funds, but lower than the average of 0.36% across all U.S. index funds and mutual funds.
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An equal-weight S&P 500 index fund is a sensible hedge against concentration risk
I have a significant portion of my own portfolio in the Vanguard S&P 500 ETF, which tracks the traditional market-value-weighted S&P 500. I have no plans to change that, but I may open a smaller position in the Invesco S&P 500 Equal Weight ETF as a hedge against concentration risk.
Additionally, the equal-weight index often outperformed the S&P 500 in previous decades. Since 1970, the equal-weight benchmark has beaten the S&P 500 during 78% of rolling 10-year periods by an annual average of 2 percentage points, according to Goldman Sachs. Only in the last decade did that pattern reverse, such that the traditional S&P 500 beat the equal-weight benchmark by an average of 3 percentage points annually.
In that context, it makes sense for investors to own positions in both an S&P 500 index fund and an equal-weight S&P 500 index fund, and to allocate a little more to the fund in which they have more confidence. That strategy should prevent catastrophic underperformance no matter which way the wind blows in the coming decade.
