Beyond Market Cap: Alternative Weighting Strategies

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Most ETFs weight their company holdings in proportion to the market capitalization (shares outstanding X share price). It seems logical to think that a company's importance in the economy is proportional to its perceived value. But historical evidence suggests that alternative weighting strategies using fundamental financial ratios often, and perhaps more often, deliver superior returns.

The easiest, cheapest, and best understood of these types of ETFs use publicly disclosed weighting methodologie. Investors today can understandably be a bit skeptical of alternative weighting schemes which are proprietary "black boxes". Two transparent weighting strategies are suitable for such investors: weighting all holdings in equal amounts and weighting based on revenues. The following graphs shows how both equal and revenue weighting (RSP and RWL) did quite well over the past year against an S&P 500 proxy (SPY):

Weighting by revenue takes the sensible position that large and important companies tend to have strong sales. How can they ultimately make big profits without it? In technology the answer is often through organic growth, but as the Tech Crash showed this can often end it tears. Weighting by revenue 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%

These have shown strong performance compared to market cap equivalent funds dating to 1979 in back testing. Standard & Poor's verified results back to 1991.

Equal-weighting dampens individual company risk by its very definition. If 500 stocks are owned in equal amounts, exposure to failure of one company is about .2% (it strays a bit before rebalancing), 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. Exxon is weighted the same as First Solar. This effect causes medium sized companies (by any measure) to predominate and true multinationals to fall into the minority. An equal weighted version of the S&P can have an average market cap of just a few Billion dollars. Equal weighting also emphasizes more fragmented industries. For instance, financials nearly doubles in importance.

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%

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 which can be an issue in typical industry ETFs. Typically Rydex equal weight company holdings do not exceed 5%.

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.

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

Referenced Stocks: RCD , RHS , RSP , RYE , RYF

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