Could This Simple Strategy Save You From the Next Bear Market?

The stock market continued to move lower on Wednesday, with market participants clearly expressing their preference for old-economy value stocks over the high-growth momentum-driven plays that performed so well throughout the last part of 2020. As has commonly been the case in the past couple of weeks, the Dow Jones Industrial Average (^DJI -0.11%) held up reasonably well thanks to its hefty helping of financial stocks, but the S&P 500 (^GSPC 0.02%) lost more ground, and the Nasdaq Composite (^IXIC 0.10%) saw even bigger declines.

Data source: Yahoo! Finance.

Some investors are realizing that the boom in tech sector companies and related stocks has left their portfolios out of balance. That was fine when it meant that their portfolios were surging higher, but lately, allocations that are overly concentrated in high-growth plays have been hazardous to investors' short-term financial health.

With that in mind, one simple strategy is starting to regain some popularity. What makes it simple is that it involves investing in the same 500 stocks that make up the S&P 500 and are the basis of so many index-tracking ETFs and mutual funds. However, the strategy has a twist that has allowed it to deliver to dramatic outperformance in the past six months -- and some have wondered if it could save investors from taking too much of a hit from the next bear market.

Image source: Getty Images.

Equality for all

Put simply, the strategy that has been so successful lately involves investing equal amounts in all of the stocks in the S&P 500. Funds like the SPDR S&P 500 (SPY -0.05%) track the S&P using the index's own market-cap-weighted methodology. That's why in that fund, almost 7% of assets are allocated to Apple (AAPL 1.27%), while oil refiner HollyFrontier (HFC) accounts for less than 0.02% of assets.

Equal-weight funds, on the other hand, ignore market capitalization. The Invesco S&P 500 Equal Weight ETF (RSP 0.14%) just invests equal amounts in all 500 S&P stocks. Naturally, the market's fluctuations will cause some stocks to rise and others to fall, so the fund occasionally rebalances to reset the weightings and make them all the same again.

What that means is that Apple, HollyFrontier, and every other stock in the S&P 500 starts out with a 0.2% weighting in an equal-weight ETF. And even after the big gains some of those individual stocks have accrued in recent months, the company with the heaviest weighting in the Invesco S&P 500 Equal Weight ETF accounts for just 0.35% of the portfolio's value.

From a big-picture standpoint, the result is a fund that looks a lot different from a traditional S&P 500 fund. The market-cap-weighted index has about 27% of its assets in tech stocks, while industrials represent less than 9% and energy less than 3%. In the equal-weight fund, tech stocks get only 15% weighting, while industrials weigh in at 14% and energy gets a 5% allocation.

When equal-weight ETFs win

Obviously, those disparities mean that when tech is doing well, a regular S&P fund will outperform an equal-weight ETF. However, over the past six months, the reverse has been true. Stocks like HollyFrontier have crushed stocks like Apple. As a result, the equal-weight fund has dramatically outperformed the S&P 500.

RSP Total Return Level data by YCharts.

Interestingly, when markets rotate, they have a larger impact on regular S&P 500 allocations than on an equal-weight fund's weightings. Because of rebalancing, the only thing that dramatically shifts the sector allocations for an equal-weight fund is when the index manager makes changes to the component companies in the index. By contrast, if the value of tech stocks falls, then its allocation in a regular S&P fund will get correspondingly smaller.

Equal-weight ETFs can't protect investors against all bear markets. If stocks fall across the board -- as they did in early 2020 -- then no weighting strategy will necessarily do better than another. However, if you think the next big correction will largely impact share prices in the segments of the market that were previously the best performers, then an equal-weight ETF could reduce your losses. It can even potentially deliver gains if certain sectors avoid the downward move entirely.