Most
ETFs
weight their company holdings by market capitalization. The
combined wisdom of all the market's investors is tough to
beat.
But that is what alternative weighting schemes attempt to do.
Fundamental ETFs have gained a lot of attention from claims that
they can outperform cap weighting with proprietary methodologies
using financial ratios. But also very popular is equal weighting,
which is transparent and inexpensive and helps to diversify.
Unfortunately, it is also an arbitrary system which shifts
exposure to smaller companies of the target index in a poorly
controlled manner.
With equal weighting every company is owned in equal amounts,
an arbitrary but simple rule. Thus the Rydex S&P Equal Weight
ETF (
RSP
) contains each S&P 500 company in equal amounts, unlike the
actual S&P where the top 10 firms account for roughly 20% of
assets and the bottom 10 less than 1%. Clearly this dampens
individual company risk. If 500 stocks are owned in equal
amounts, risk to the portfolio of failure of one company is about
.2% (it strays a bit before occasional rebalancing), a far cry
from the 1%-5% exposure to each of the top 10 holdings of the
S&P 500.
One might expect RSP to also dampen volatility compared to the
S&P, but in a five-year comparison with the SPDR S&P 500
ETF (NYSEArca:SPY), this was not the case. RSP dropped and
recovered faster than its target index:
Performance comparisons depend heavily on periods examined. If
over the very long run equal-weighting slightly outperforms
market cap, it should come as no surprise because smaller
companies should outperform larger ones, according to economists.
We make nothing of short runs where one weighting scheme may win,
as equal weighting has done lately.
For us it is not at the major index level but rather at
sub-indexes where dampening of individual company risk shines,
because it is here that mega-cap companies skew results.
Correlations are quite high inside an industry, so there is
little danger of missing out on a fundamental move in the
sector.
So investors should be quite pleased to have at their disposal
nine ETFs which 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%.
Equal weighting also creates various effects which one can
consider perverse or attractive depending on the circumstances.
In addition to causing the smallest of the large companies to
predominate, true multinationals to fall into the minority, and
liquidity can drop. Equal weighting also emphasizes more
fragmented industries. For instance, financials rises in
importance, and at least in recent years this meant much greater
volatility.
For passive investors with small-cap holdings, equal weighting
plays havoc with attempts to allocate seamlessly across company
sizes. While its uniform holdings might seem tidy on its face, in
percentage terms the shift to smaller cap is anything but
uniform. The smaller the company, the greater the shift. Real
dislocation will occur at the edge of the S&P 500, at the
501st company. This does not happen with cap weighted large, mid
and small-cap funds. From the portfolio perspective, this is poor
control of size shifting.
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.
In our view, equal-weighting is most useful in allocation of
industries.
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.