Alternative Weighting with Transparency

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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.



    The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



    This article appears in: Investing , ETFs


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