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.