Research has shown that equally weighted indices have historically posted long-term outperformance1 over their benchmarks—largely driven by their exposures to small size and value along with associated risk premia, in addition to a healthy dose of concentration reduction.2 However, in accessing compensated factors and reducing concentration, the S&P 500® Equal Weight Index could elicit some undesirable ESG consequences.
With many investors looking to integrate ESG considerations into their portfolios, is it possible to gain the benefits of equal weighting while incorporating ESG criteria? This question raises three sub-questions.
- Can ESG benefits be gained relative to the S&P 500 Equal Weight Index?
- Can factor exposures associated with equal weighting be gained within an ESG framework?
- Can we reduce concentration in a few names, while excluding companies that are undesirable from an ESG standpoint?
To give the game away early (in case you want to stop reading here): yes, yes, and yes.
Before addressing these questions, it helps to understand how the index is constructed (see Exhibit 1).
Based on this index construction, how does the S&P 500 Equal Weight ESG Leaders Select Index perform? We can see an excess return over the S&P 500 Equal Weight Index (see Exhibit 2), with comparable volatility, realizing an improved risk-adjusted return over each period examined historically (see Exhibit 3).
Can ESG benefits be gained? There were large improvements in both the S&P DJI ESG Score and carbon intensity1 at the index level, with the S&P 500 Equal Weight ESG Leaders Select Index relative to the S&P 500 Equal Weight Index achieving a stronger ESG profile and lower carbon footprint (see Exhibit 4).
Can factor exposures be maintained? The only significantly difference in exposure we can see is small size, as the S&P 500 Equal Weight ESG Leaders Select Index is not quite as exposed. But it still has more exposure to small size compared to the market-cap-weighted S&P 500 or S&P 500 ESG Index.
Can we reduce concentration within an ESG Framework? While there is more weight in the largest stocks in the ESG equally weighted index than in the S&P 500 Equal Weight Index, there is still a large concentration reduction from cap weighting—relative to either the S&P 500 or S&P 500 ESG Index.
Ultimately, if the factor exposures and concentration reduction of equally weighted indices with an improved ESG footprint sounds good, the S&P 500 Equal Weight ESG Leaders Select Index may be a good fit.
1 Historical long-term outperformance was over market-cap-weighted indices.
2 Rashid (2021) shows equally weighted indices have performed well during economic recovery. Bellucci & Gunzberg (2018) and Edwards, Lazzara, Preston & Pestalozzi (2018) highlight increased exposure of equal weighted indices to small size and value, while Ganti (2021) observes value exposures by equally weighted indices. Edwards, Lazzara, Preston, & Pestalozzi (2018) and Preston (2021) discuss benefits of concentration reduction.
3 We define carbon intensity as Scope 1 + Scope 2 + Scope 3 emissions/enterprise value including cash (EVICThe posts on this blog are opinions, not advice. Please read our Disclaimers.