So many ETFs weight holdings by market capitalization that one
might reasonably conclude market cap has proven its superiority.
Not so. Alternative weighting methods show compelling
performance. The easiest, cheapest, and best understood of these
types of ETFs use publicly disclosed weighting methodologies.
Transparent alternative weighting is timely. A company's
market value is often distorted beyond reason in times of greed
or panic. The past decade has seen plenty of both. By employing
less volatile measures, alternative weighting schemes can help
avoid trouble. And investors today are understandably nervous
about anything hidden. Many alternative weighting schemes are
proprietary "black boxes".
Transparent methodologies set a modest goal of deploying
simple formulas to beat cap-weighting reliably at fairly low
cost. These open methodologies are easy to analyze and build
portfolios with. (See our reports on fundamental and high
dividend yield ETFs for more proprietary strategies.)
Two transparent weighting strategies predominate: weighting
all holdings in equal amounts and weighting based on revenues,
which has been particularly impressive. Both weighting strategies
can track market cap closely for months at a time, and then
diverge sharply. They are not radical departures from the norm,
but they are different:
Equal-weighting dampens individual company risk. If 500 stocks
are owned in equal amounts, exposure to failure of one company is
.2%, a far cry from the 1%-5% exposure to each of the top 10
holdings of the S&P 500. But this comes at the price of
losing exposure to true economic activity. Microsoft represents a
huge chunk of actual business activity, but it is weighted as
little as a minor computer player. This effect causes medium cap
exposure (by any measure, not just capitalization) to rise and
large cap exposure to fall. Whereas the S&P 500 has a
weighted average market cap of about $68 Billion, its equal
weighted version has an average market cap of a paltry $2
Billion.
Equal weighting also emphasizes certain industries over others
because of their predominance or scarcity among large or mid-cap.
For instance, financials take up a modest 10% of the S&P 500
but rise to 18% when equal weighted. If one is bullish on
financials and consumer discretionaries in 2009, equal weighting
does the trick, but otherwise the regular S&P 500 is the best
choice.
Equal-weighted ETFs are dominated by the Rydex line,
summarized by the broad Rydex S&P Equal Weight ETF (
RSP
), which weights the S&P 500 equally and sports annual fees
of 0.4%. It's the default choice in this area.
Nine ETFs chop the S&P 500 by industry sector to allow
fine tuning:
- Rydex S&P Equal Weight Consumer Discretionary ETF (
RCD
), annual fees: 0.5%
- Rydex S&P Equal Weight Consumer Staples ETF (
RHS
), annual fees: 0.5%
- Rydex S&P Equal Weight Energy ETF (
RYE
), annual fees: 0.5%
- Rydex S&P Equal Weight Financial ETF (
RYF
), annual fees: 0.5%
- Rydex S&P Equal Weight Health Care ETF (
RYH
), annual fees: 0.5%
- Rydex S&P Equal Weight Industrials ETF (
RGI
), annual fees: 0.5%
- Rydex S&P Equal Weight Materials ETF (
RTM
), annual fees: 0.5%
- Rydex S&P Equal Weight Technology ETF (
RYT
), annual fees: 0.5%
- Rydex S&P Equal Weight Utilities ETF (
RYU
), annual fees: 0.5%
- Rydex S&P Equal Weight Consumer Discretionary ETF (
RCD
), annual fees: 0.5%
- Rydex S&P Equal Weight Consumer Staples ETF (
RHS
), annual fees: 0.5%
- Rydex S&P Equal Weight Energy ETF (
RYE
), annual fees: 0.5%
- Rydex S&P Equal Weight Financial ETF (
RYF
), annual fees: 0.5%
- Rydex S&P Equal Weight Health Care ETF (
RYH
), annual fees: 0.5%
- Rydex S&P Equal Weight Industrials ETF (
RGI
), annual fees: 0.5%
- Rydex S&P Equal Weight Materials ETF (
RTM
), annual fees: 0.5%
- Rydex S&P Equal Weight Technology ETF (
RYT
), annual fees: 0.5%
- Rydex S&P Equal Weight Utilities ETF (
RYU
), annual fees: 0.5%
Rydex S&P Equal Weight Consumer Discretionary ETF (
RCD
), annual fees: 0.5%
Rydex S&P Equal Weight Consumer Staples ETF (
RHS
), annual fees: 0.5%
Rydex S&P Equal Weight Energy ETF (
RYE
), annual fees: 0.5%
Rydex S&P Equal Weight Financial ETF (
RYF
), annual fees: 0.5%
Rydex S&P Equal Weight Health Care ETF (
RYH
), annual fees: 0.5%
Rydex S&P Equal Weight Industrials ETF (
RGI
), annual fees: 0.5%
Rydex S&P Equal Weight Materials ETF (
RTM
), annual fees: 0.5%
Rydex S&P Equal Weight Technology ETF (
RYT
), annual fees: 0.5%
Rydex S&P Equal Weight Utilities ETF (
RYU
), annual fees: 0.5%
They go head-to-head against cap-weighted sector ETFs such as
the Select Sector SPDRs line. The Rydex ETFs deliver substantial
diversification of company-level risk. For example, the Select
Sector consumer staples XLP contains about 11% Walmart and 16%
Procter & Gamble. In the comparable equal weight RHS, which
holds the same 41 companies, no firm exceeds 4%.
Another equal-weighted ETF is the First Trust NASDAQ-100 Equal
Weighted ETF (NasdaqGM:QQEW), with annual fees of 0.6%. It is
essentially a collection of large cap stocks which happen to
trade on one US exchange, so it's less than ideal for cleanly
allocating assets. The NASDAQ's propensity for high-tech
companies with good liquidity make it useful for traders and
high-tech investors. And it isn't as popular as the S&P 500
index, so fewer arbitrageurs try to front-run companies soon to
be added or deleted from the S&P.
Weighting by revenue, the other major transparent methodology,
is one of our favorites. It tends to load up on companies with
large, proven operations and avoids hype.
This strategy is dominated by the aptly named RevenueShares
line:
- RevenueShares ADR ETF (NYSEArca:RTR), annual fees:
0.49%
- RevenueShares Financials Sector ETF (NYSEArca:RWW),
annual fees: 0.49%
- RevenueShares Large Cap ETF (NYSEArca:RWL), annual fees:
0.54%
- RevenueShares Mid Cap ETF (NYSEArca:RWK), annual fees:
0.54%
- RevenueShares Navellier Overall A-100 ETF (NYSEArca:RWV),
annual fees: 0.6%
- RevenueShares Small Cap ETF (NYSEArca:RWJ), annual fees:
0.54%
- RevenueShares ADR ETF (NYSEArca:RTR), annual fees:
0.49%
- RevenueShares Financials Sector ETF (NYSEArca:RWW), annual
fees: 0.49%
- RevenueShares Large Cap ETF (NYSEArca:RWL), annual fees:
0.54%
- RevenueShares Mid Cap ETF (NYSEArca:RWK), annual fees:
0.54%
- RevenueShares Navellier Overall A-100 ETF (NYSEArca:RWV),
annual fees: 0.6%
- RevenueShares Small Cap ETF (NYSEArca:RWJ), annual fees:
0.54%
RevenueShares ADR ETF (NYSEArca:RTR), annual fees: 0.49%
RevenueShares Financials Sector ETF (NYSEArca:RWW), annual
fees: 0.49%
RevenueShares Large Cap ETF (NYSEArca:RWL), annual fees:
0.54%
RevenueShares Mid Cap ETF (NYSEArca:RWK), annual fees:
0.54%
RevenueShares Navellier Overall A-100 ETF (NYSEArca:RWV),
annual fees: 0.6%
RevenueShares Small Cap ETF (NYSEArca:RWJ), annual fees:
0.54%
These have shown strong outperformance of comparable market
cap dating to 1979 via back testing, with Standard & Poor's
verifying results back to 1991. One-year outperformance of
comparable cap-weighted indexes have been impressive: 0.2% for
large cap, 7.6% for mid-cap and 10.6% for small cap through May
2009. We caution that recent performance is a poor predictor of
future results.
Any investor slicing and dicing their equities into large, mid
and small-cap portions should examine these funds as a
buy-and-hold alternative to the usual fare.
Co-founder of indexfunds.com, author of two books on
investing, and founder of ETFzone.com, Will has been writing on
indexing issues for 8 years. He holds an MBA from the
University of Texas at Austin.
Co-founder of indexfunds.com, author of two books on
investing, and founder of ETFzone.com, Will has been writing on
indexing issues for 8 years. He holds an MBA from the University
of Texas at Austin.