From the May 2011 issue of Research Magazine • Subscribe!

Watch Your Weighting

Analyzing the merits of equal weighting

One of the basic fundamentals for enjoying a healthy lifestyle is having a balanced diet. Essentially it means eating an equal portion of all the major food groups because each group contributes its own unique set of nutrients the human body needs to function optimally.

If there was ever an investment strategy that best fit the “balanced diet” mold, the equal-weighting strategy would be it. How does equal weighting work? What are the advantages and disadvantages of this strategy? And, can it minimize your client’s investment risk?

Before we cover the basics of equal-weighted ETFs, it’s important to have a basic understanding of the traditional or standard methodologies for assembling stock indexes.

Weighting securities by their market capitalization or market size is still the most popular and traditional method for index construction. Securities with the largest market size will dominate the performance of the index whereas smaller issues have less influence.

Widely followed benchmarks like the Nasdaq Composite (ONEQ) and the S&P 500 (SPY) follow a market-cap-weighted method, as do broader measures of U.S. stocks like the Russell 3000 (IWV) and Wilshire 5000 (WFVK).

ETFs linked to traditional indexes attempt to track the performance of the market and nothing more, whereas any indexing strategies outside of this realm are attempting to do more and therefore not necessarily representative of “the market.”

Equal Weighting 101

While it may sound complex, equal weighting is quite simple. For stock indexes, instead of weighting companies by their market size or market cap, each company is assigned a fixed or equal weight. In other words, each company within the index receives the exact same ownership percentage. This type of strategy prevents stocks with a large market size from dominating the performance and volatility of the index. Most equal-weighted ETFs are rebalanced quarterly to stay true to their investment objective.

The Rydex S&P Equal Weight ETF (RSP) owns stocks within the S&P 500, as does SPY, but rather than weighting stocks by their market size, RSP assigns each stock an equal weight of 0.20 percent. This minimizes the possibility of stocks with a large run-up in their market value dominating the index’s performance.

The benefit of equal weighting is evidenced by the performance differential between the equally weighted S&P 500 and the market-cap-weighted S&P 500. Over the last 20 years an equally weighted S&P 500 portfolio has beaten the cap-weighted portfolio by nearly 2 percent per year.

In an attempt to build upon its success with equally weighted U.S. stock indexes, Rydex recently launched foreign ETFs that use an identical strategy. The Rydex MSCI EAFE Equal Weight ETF (EWEF) owns international stocks in developed countries in equal proportions while the Rydex MSCI Emerging Markets Equal Weight ETF (EWEM) takes the same approach with emerging market stocks. Both funds charge annual expenses of 0.70 percent.

Sector Equal Weighting

Another version of equal weighting is being applied to industry sectors. The ALPS Equal Sector Weight ETF (EQL) is an ETF of ETFs that invests equal proportions in each of the nine Select Sector SPDR funds. EQL owns an equal 11.11 percent share of the Select Sector SPDRs tracking the nine S&P 500 sectors. The fund is rebalanced back to its original weighting target every quarter.

Besides taking the guesswork out of which industry sectors to specifically own, EQL minimizes the big sector run ups that can distort the risk and performance of regular market-cap-weighted benchmarks like the S&P 500.

“Most equal-weight indexes are based at the stock level,” states Jeremy Held, ALPS director of product research. “EQL is an important extension of the equal-weight concept in that it addresses sector risk, which we consider to be a much more important and fundamental risk to client portfolios than individual stocks.” Held adds: “An equal sector strategy minimizes the negative impact of any one sector by diversifying over multiple sectors.”

Rydex also offers eight equal-weighted S&P 500 industry sector ETFs. The fund holdings mirror that of the popular Select Sector SPDRs, but all stocks within the Rydex sector funds are given an equal assignment within the portfolio.

With this year’s resurgence of the equity market, financial stocks (RYF), basic materials (RTM) and technology (RYT) have all been top performers. Not to be overlooked are energy stocks (RYE), which have climbed 50.43 percent since the year’s start.

Weighty Tax Implications

The equal-weight strategy is impressive, but does have its drawbacks. “Portfolio turnover does tend to be higher in an equal-weighted index compared to a traditional cap-weighted index,” says Ken O’Keeffe, managing director of indexes at Russell Investments. As such, advisors should closely monitor the tax distributions of ETFs that use an equal-weight strategy.

Such tax consequences should be kept in perspective, though. “When measuring the costs associated with an equal-weighted index, we feel it is more appropriate to measure the costs against other indexes or funds that are designed to provide outperformance such as active management portfolios,” says O’Keefe. “The turnover of equal-weighted indexes when compared to active management portfolios is lower.”

Cutting Overweight Risk

Following the “balanced diet” analogy we used earlier, an overweight body can pose serious health risks. Similarly, an overweight investment portfolio with too much exposure to one or two sectors can be an acute threat.

One example of this was during the 2000-02 bear market. Many market-cap-weighted index funds got clobbered because of too much exposure to large-cap technology stocks. This same phenomenon occurred again during the 2008 financial crisis, when cap-weighted funds suffered steep losses because of overexposure to financial and banking stocks. On the other hand, equal-weighted indexes were impacted, but less so.

Can equal-weighted portfolios help you to reduce risk? While there’s no full proof method for preventing market losses, equal weighting can help you to avoid over-concentrated stock positions.

Conclusion

Through both bull and bear markets, mutual funds and ETFs that follow market-cap indexes continue to outperform most actively managed funds. Equal weighting aims to improve on those results with a very simple formula.

Generally, the performance of equal-weighted ETFs is best when mid- and small-cap stocks are outperforming large company stocks (because equal-weighted shares have a lower average market cap). Conversely, equal-weighted ETFs are likely to fall harder and faster when mid- and small-cap stocks tank.
All investment strategies, even the best of them, will have periods of underperformance. Nevertheless, equal-weight ETFs offer compelling historical results that advisors should not overlook.

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