From the September 2006 issue of Wealth Manager Web • Subscribe!

The Weighting Game

I'm not talking about "weight" as in counting calories. I'm talking about understanding the difference between an ETF whose holdings are weighted based on market capitalization versus an ETF that equal weights its components versus an ETF that weights its components based on dividends or some other fundamental data.

Indeed, the ETF world is becoming one big weighting game. Remember, all ETFs are based on an underlying index. That means that the success or failure of an ETF depends on the performance of that underlying index. And it's not just about how the components in that index perform. Perhaps even more importantly, it's about how those components are weighted.

To understand how an index's weighting scheme can impact performance, let's compare the returns of the market-capitalization-weighted S&P 500 index versus an equal-weighted S&P 500 index. An index that is weighted by market capitalization assigns the heaviest weightings to those stocks with the largest market capitalization (the per-share stock price multiplied by the number of outstanding shares). Thus, in the market-cap-weighted S&P 500, the stocks carrying the most weight--and, therefore, having the greatest influence on the index's performance--are the megacaps such as Exxon Mobil, GE, Citigroup and Microsoft. Conversely, in an equal-weighted index, all of the stocks carry exactly the same weight. So in an equal-weighted S&P 500 index, Exxon Mobil and GE have exactly the same influence on the index's performance as the smallest market-cap stocks in the index. Again, both the market-cap S&P 500 and the equal-weighted S&P 500 have the same components. The only difference between them is how those components are weighted.

So, how do the returns compare? Interestingly, the equal-weighted S&P 500 index has crushed the market-cap-weighted S&P 500 index over the last five years, posting an average annual return of 8.0 percent versus just 2.5 percent for the market-cap S&P 500 index. Unfortunately for S&P 500 indexers, the vast majority of the billions of dollars invested in the S&P 500 are tied to the market-cap-weighted index, not the equal-weighted S&P 500. That's not for the lack of an equal-weighted option. Indeed, the Rydex S&P Equal Weight ETF (RSP) has been trading since April 2003 and has trounced the market-cap-weighted SPDR ETF (SPY) over the last three years. Yet the Rydex S&P Equal Weight ETF has just $1.6 billion in assets versus the $55 billion invested in the SPDR.

In other words, you could say that SPDR investors have left in the vicinity of $5 to $10 billion in profits on the table over the last three years because they bet on the wrong weighting scheme.

Why does a weighting scheme matter so much to the performance of an ETF? The performance of your portfolio generally depends on how much money you have in each of the underlying investments, sector exposure and size exposure (large caps versus midcaps versus small-cap stocks). How an index is weighted will affect all three of these important areas.

In the case of the market-cap-weighted S&P 500 versus an equal-weighted S&P 500, it is rather obvious how the weighting scheme affects individual securities. In the market-cap-weighted ETF, the top 10 holdings account for nearly 20 percent of the portfolio. In the equal-weighted ETF, the top 10 holdings account for approximately 2 percent of the total portfolio. Obviously, the market-cap weighted S&P 500 will have a much more difficult time sustaining gains when the largest market-cap stocks are out of favor.

What may not be so obvious is how an index's weighting scheme affects industry representation. The table "The Importance of Cap Weights" on page 60 shows how different weighting schemes for the S&P 500 index can have a significant impact on sector exposure. And these differences in sector exposure can play a big role in the performance of the index.

Finally, how an index is weighted will also have major impact on the index's size representation. The S&P 500 is viewed as a large-cap market index. Still, within the S&P 500 there are huge differences in company sizes. For example, the bottom 50 stocks in the S&P 500 currently have market capitalizations below $3.5 billion. These are considerably smaller companies than the megacap stocks such as Exxon Mobil, GE, Citigroup and Microsoft, which have market caps above $200 billion. In a market-cap-weighted index, those small market-cap stocks matter little to the index, meaning that a market-cap-weighted S&P 500 truly is a megacap market index. When you equal weight the components of the S&P 500, however, smaller and mid-sized companies within the index have much greater influence. Therefore, the equal-weighted S&P 500 is a much more diversified index in terms of company size than its market-cap-weighted counterpart.

When you break down the ways that the weighting scheme affects individual stocks, sectors and size, it is not surprising that the equal-weighted S&P 500 has been winning handily in recent years. The last several years have been characterized by strength in smaller companies as well as weakness in megacap stocks. And if you expect these trends to continue, you should expect outperformance from an equal-weighted index to continue as well.

Perhaps buoyed by the failure of market-cap-weighted indices in recent years--as well as a need to differentiate their products in an increasingly crowded ETF marketplace--ETF sponsors have been creating new products based on innovative weighting schemes. For example, in addition to ETFs that equal weight their components, there are new ETFs that weight components based on dividends or other fundamental data. (See "ETF Weighting Strategies" above).

The Dow Jones Select Dividend ETF (DVY), for example, weights its components based on indicated dividends. Also dividend-based is a brand new entry--the WisdomTree family of ETFs. WisdomTree weights all of its ETFs on a proprietary weighting scheme based on dividends. A different fundamental weighting scheme is used by the Powershares FTSE RAFI US 1000 ETF (PRF). This ETF weights components based on four fundamental factors: total cash dividends, free cash flow, total sales, and book equity value.

The emergence of fundamental indices is one of the more controversial developments in the index and ETF world. Fundamental indexers believe market-cap-weighted indices have a variety of problems, such as awarding greater influence to overvalued stocks. Fundamental indexers believe you can outperform market-cap-weighted indices simply by adding some fundamental criteria that tilt weightings toward stocks offering better values. Fundamental indices also generally give greater weighting to smaller stocks in the index than do market-cap indices.

Opponents of fundamental indices say that they are, in fact, not indices at all. Rather, they say they are actively-managed strategies masquerading as indices. Furthermore, these opponents argue that fundamental indices--because of their higher turnover and more frequent component rebalancing--are much less tax efficient than market-cap-weighted indices.

Understand that the point of this discussion is not to argue that equal-weighted indices are better than market-cap-weighted indices, or that ETFs weighted by such fundamentals as dividends or free cash flow are the optimum approach to index construction. Indeed, for much of the 90s, when megacap stocks were popular, market-cap-weighted indices performed well. More recently, the good performers have been equal-weighted indices, with their bias toward smaller companies. And fundamental indexers point to their superior back-tested results over market-cap-weighted indices as reason to support their products. My point is that, quite frankly, it is a waste of time to say whether one index-weighting system is better than the other. What is most important is understanding the various weighting schemes and determining which makes the most sense for your clients.

Remember that you are paid to put your client assets into investments--including ETFs--to achieve a maximum level of return at the client's appropriate level of risk. That puts a premium on knowing what options you have as an indexer and choosing those that make the most sense for your client. Thus, in certain circumstances, it may make perfect sense to choose a market-cap-weighted index, especially if your client's other investments are generally equal-weighted. Likewise, it may make perfect sense to choose an equal-weighted index if your client already has a big chunk of his or her money tied up in the megacap stocks that rule market-cap-weighted indices and needs more diversification. And perhaps it may make sense to put a portion of your client's money into a dividend-weighted ETF if his or her cash flow needs demand a higher level of income. Furthermore, an ETF based on certain market fundamentals may make sense as a way to further diversify a client's portfolio across quantitative investment strategies.

Of course, at the end of the day it's quite possible that these weighting schemes will make little difference in returns over the long run. Indeed, while market-cap-weighted indices are by far the most prevalent in the index world, the oldest and most widely recognized index in the world-- the Dow Jones Industrial Average--is not market-cap weighted, but price weighted. The component stocks that have the most influence on the Dow's performance are the highest-priced stocks. In fact, many Dow bashers point to the price-weighted nature of the Dow as a major drawback for the index and a reason the market-cap-weighted S&P 500 index is a better index for benchmarking large-cap stock performance. What's noteworthy for our discussion, however, is that despite two distinctly different weighting schemes (not to mention that the Dow has just 30 stocks versus 500 for the S&P 500 index), the performance of the Dow and the S&P 500 has been quite similar over long periods of time. Indeed, while the Dow and S&P 500 may vary significantly from year to year, the long-run correlation coefficient of returns between the two indices is nearly 1.0.

Bottom line: Because most ETFs have yet to see their third birthdays--and many of the new fundamentally weighted ETFs are less than a year old-- it is way too early to tell whether these "better mousetraps" will, indeed, provide better returns than market-cap-weighted indices over several market cycles.

I guess we'll just have to weight and see.

Chuck Carlson, CFA, is chief executive officer of Horizon Investment Services and the author of Winning With The Dow's Losers (HarperBusiness). David Wright, CFA, provided research assistance for this article.

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