Investors who simply want to track the market generally tend to choose to invest in the S&P 500. Based on how the index is created -- with a broad, diverse representation of the overall economy -- it is a very solid choice.
There's just one problem right now. The S&P 500 is trading at lofty levels, with a high concentration in technology stocks. Here's why investors who want to own the S&P 500 index might find it a smart move to buy the Invesco S&P 500 Equal Weight ETF (RSP 0.37%).
What is the S&P 500?
The S&P 500 is a list of roughly 500 U.S. stocks that have been hand-selected by a committee. The actual goal isn't for the stocks to be representative of the market; the intent is for the stocks, as a group, to represent the broader U.S. economy. The companies that get chosen are usually large and economically important, as you might expect.
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The index employs a market capitalization weighting method. This essentially means that the largest companies comprise a larger percentage of the index. Thus, the largest companies have the biggest impact on the S&P 500 index's performance. Since the largest companies tend to have the biggest impact on the economy, using market cap weighting makes a lot of sense.
There are several S&P 500 mutual funds and exchange-traded funds (ETFs) available for investors to purchase. Since they all do the exact same thing, it is probably a smart move to simply buy the cheapest alternative. For example, Vanguard S&P 500 ETF (VOO 0.03%) has an expense ratio of just 0.03%, which is as close to free as you are likely to find on Wall Street. However, there's another option you may want to consider.
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The problem with market cap weighting
Market cap weighting is a logical and appropriate way to mimic the economy. But it sometimes leads to problems, notably including concentrating the S&P 500 in hot stocks and sectors. Currently, for example, the technology sector accounts for approximately 35% of the index, which is a significant proportion. Three stocks, Nvidia, Microsoft, and Apple, account for a fairly material 21% of the index.
While the tech focus has helped push the S&P 500 index to record levels, it has also left the index highly concentrated and expensive from a valuation perspective. The average price-to-earnings ratio of the index is nearly 29, and the average price-to-book value ratio is 5.2.
An alternative to the S&P 500 that may interest more conservative investors is Invesco S&P 500 Equal Weight ETF. As the name implies, it doesn't use market cap weighting, instead opting for equal weighting. This ETF costs a bit more, with an annual expense ratio of 0.2%. However, all the stocks in the ETF have the same opportunity to impact performance because of the use of equal weighting.
Tech stocks make up roughly 15% of the ETF, which is similar to the weighting of the industrial and financial sectors, with healthcare not too far behind. The top three stocks in Invesco S&P 500 Equal Weight ETF -- Warner Bros Discovery, Micron Technology, and Western Digital -- account for roughly 1% of assets. Note that this list doesn't include Nvidia, Microsoft, or Apple.
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On the valuation side of things, Invesco S&P 500 Equal Weight ETF looks a lot more attractive as well. The average P/E ratio is just under 21. The average P/B ratio is 3. So, more diversification and better valuation than the traditional S&P 500 index today.
It could be smart to err on the side of caution
There's nothing wrong with a long-term investor buying an S&P 500 index tracker. If you do, opt for the cheapest alternative you can find, which will likely lead you directly to Vanguard S&P 500 ETF. But if you think the market is a bit too pricey today, you have a solid alternative in Invesco S&P 500 Equal Weight ETF.
Sure, it will cost you a little more to own, but it won't leave you as exposed to the tech sector concentration that has emerged in the S&P 500 index thanks to market capitalization weighting. When a bear market arrives -- and one will eventually arrive -- a $500 investment in Invesco S&P 500 Equal Weight ETF, which will net you around 2.6 shares, could save you some of the pain of the drawdown.
