(This Aug. 29 story has been refiled to correct a grammatical error in paragraph 4)
By Sruthi Shankar and Medha Singh
(Reuters) - Equal-weighted exchange-traded funds (ETFs) have attracted record investments in recent months as signs of an improving U.S. economy and towering valuations of megacaps push investors to look for bargains in traditional economy-linked sectors.
An equal-weighted version of an index assigns uniform weight to each constituent regardless of its size, unlike market capitalization-based indexes where bigger companies tend to have an outsized influence.
A dizzying tech rally this year, fueled by optimism over artificial intelligence and hopes that the U.S. Federal Reserve is nearly done raising interest rates, has left money managers increasingly cautious about the euphoria surrounding megacaps.
As a result, investing in equal-weighted ETFs that provide a more diversified approach and offer exposure to old economy-linked sectors such as energy and manufacturing is coming back in favor as investors look to broaden their exposure beyond Big Tech.
Laura Cooper of BlackRock said the company's "highest conviction call" in the United States is the S&P 500 equal-weight.
"Cyclically tilted sectors, that have been lagging more recently, have started to tick higher on soft landing hopes," said Cooper, a senior macro investment strategist for iShares EMEA at asset manager BlackRock.
"We are seeing disinflation trend persist in the U.S. alongside indicators that suggest that the Fed is likely near the end of their hiking cycle."
The $42-billion Invesco S&P 500 equal-weighted ETF, which mirrors the performance of the S&P 500 equal-weight index, saw inflows of $8.80 billion from the beginning of June through Aug. 25, according to Refinitiv Lipper data.
In comparison, the much larger $402-billion SPDR S&P 500 ETF Trust, which tracks moves in the market cap weighted S&P 500, bled $10.88 billion during the same period.
The fund shed about $4 billion in July, its biggest outflow in five months.
"People are clearly allocating to equal-weighted tracker because they think the tech rally has gone too far and they are not comfortable with such concentration in the Magnificent Seven," Dan Boardman-Weston, CEO at BRI Wealth Management, said.
Shares of Apple, Microsoft, Amazon, Nvidia, Google-parent Alphabet, Tesla and Facebook-owner Meta Platforms, the so-called "Magnificent Seven", have soared this year, prompting concerns about risks from over-concentration.
They represent more than a quarter of the S&P 500's market value.
Invesco S&P 500 equal-weighted ETF drew $4.85 billion inflows in June, the most since the fund was launched in 2003, followed by $3.53 billion in July, the second highest on record.
That compares with inflows of $352.9 million in June and outflows of $32.36 million in July in the fund, just a year earlier.
The appetite for diversifying portfolios has improved since June as signs of falling inflation and a resilient U.S. economy raised hopes that the Fed will be successful in bringing inflation under control without triggering a recession.
The Direxion Nasdaq 100 equal-weighted index shares fund, which has over $800 million in assets under management, has seen inflows of $213.4 million from June to Aug. 25.
That is shaping up to be the best three-month performance of the fund in more than a year, indicating investor preference for smaller tech companies.
For the equal-weighted indexes to continue their outperformance, stocks outside of the trillion-dollar club will have to shine.
"Equal weight needs energy, financials and healthcare to have a chance to push it ahead as we approach year-end," Jake Dollarhide, co-founder of Longbow Asset Management Company, said.
The S&P 500 sectors sensitive to economic growth including energy and industrials have gained 10.6% and 8.3% in the past three months, outperforming the tech index's 3% rise.
"Our highest conviction calls if we look at the U.S. is the energy sector. We think valuations are exceptionally depressed and positioning is light," BlackRock's Cooper said.
(Reporting by Sruthi Shankar and Medha Singh in Bengaluru; Editing by Sweta Singh and Shounak Dasgupta)