Why you should own equal-weighted S&P 500 index vs. the market-cap version

Investing.com -- Morgan Stanley analysts are advocating for the equal-weighted S&P 500 index as a better risk-adjusted investment option compared to the traditional market-cap-weighted version.

Morgan Stanley Wealth Management said in a note Monday that as markets approach a critical phase with the Federal Reserve poised to adjust monetary policy, the case for equal-weighted exposure becomes more compelling.

In their latest note, Morgan Stanley highlights the potential mismatch between risk and reward for investors relying solely on market-cap-weighted indices.

“For equity investors exclusively exposed to the passive market-cap-weighted index, risk may be mismatched with the nuances of the forward trajectory,” they warn.

"When it comes to 'sticking the landing,' we are entering the danger zone: Stay at maximum diversification," said the investment bank. "Consider owning the equal-weighted S&P 500 Index as better risk-adjusted exposure than the market-cap-weighted version."

The analysts believe that with the economy moving into the “show me” phase, where the focus shifts from "when" to "how far and how fast" the Fed will act, diversification is crucial.

Morgan Stanley points out that the current market valuations are relatively rich, and earnings expectations are ambitious, particularly as stocks remain decoupled from other asset classes.

In this environment, they recommend owning the equal-weighted S&P 500 index to achieve better risk-adjusted exposure. This approach ensures maximum diversification across sectors, offering balanced exposure to financials, industrials, energy, healthcare, and infrastructure-linked stocks, all of which present compelling opportunities.

The note also emphasizes defensive plays, suggesting sectors like residential REITs and utilities. Additionally, Morgan Stanley says looking beyond U.S. assets can be accretive to portfolios.

Ultimately, the analysts conclude that, while the much-anticipated “soft landing” is still possible, market positioning should reflect caution. As a result, they believe the equal-weighted S&P 500 offers a more balanced and diversified approach, especially in a time of economic uncertainty.

Source: Investing.com