What Are You Weighting For?

By
A A A
Share |

All too often it seems advisors zero in on an investment theme and choose the largest or most liquid ETF in that segment without regard to the underlying index strategy. Those days should be over, because it's pretty clear that not all index methodologies are created equal.

Looking at the slew of available ETFs that canvass the financial sector in a recent two-year period, we examined how the performance of funds tracking the same segment was affected by the methodology used to select and weight constituents. Between December 2008 and December 2010, Rydex's equal-weighted index strategy and First Trust's Intellidex index markedly outperformed the rest of the group.

And the biggest of the group, a market-cap-weighted offering from State Street Global Advisors, got outperformed by a revenue-weighted ETF from RevenueShares that also has a large-cap tilt. The only fund that SSgA's Financial Select Sector SPDR (NYSEArca:XLF) beat was an ETF from PowerShares that uses a one-tiered-weighted index.

In short, making relatively minor tweaks to the same universe of stocks can produce a wide array of return patterns and risk exposures. An equal-weighted strategy will likely outperform a traditional market-cap portfolio in a rising market where growth companies outperform value. However, alternative weighting strategies tend to be more expensive than cap-weighted strategies, accelerating tracking error.

All of these nuances point to an undeniable conclusion:It's high time that advisors and investors in general understand that different weighting schemes yield different returns and, crucially, a bit of homework will make sure investors know what they're getting into.

How A Weighting Strategy Impacts Costs

To compare how the various index methodologies performed relative to each other, we chose one fund to represent each weighting methodology. The funds and their index strategies are:

FXO XLF RWW PFI RYF
2-Year Performance 61.37% 35.42% 52.43% 11.45% 65.90%
  • SSgA's Financial Select Sector SPDR (NYSEArca:XLF), based on a market cap weighted index
  • Rydex's S&P 500 Equal Weight Financial ETF (NYSEArca:RYF), based on an equal weighted index
  • PowerShares' Dynamic Financial Sector Portfolio (NYSEArca:PFI), based on a proprietary index that uses growth and value metrics to rank companies, and then weights them equally
  • First Trust Financials AlphaDEX Fund (NYSEArca:FXO), based on a proprietary index that uses growth and value metrics to rank and weight constituents from the large-cap Russell 1000 Index
  • RevenueShares' Financials Sector Fund (NYSEArca:RWW), based on a revenue-weighted index

2-Year Performance

To minimize the influence of factors other than weighting methodology, whenever possible, we focused on funds whose constituents were pulled from the same universe.

State Street's XLF, Rydex's RYF and RevenueShares' RWW each draw their components from the financial sector of the S&P 500, while PowerShares' PFI and First Trust's FXO have broader selection universes.

It's no accident that XLF, at 0.20 percent a year, is the cheapest of the funds we surveyed, as the fund's underlying index is taken exclusively from the S&P 500 and has a large-cap tilt. It's also the largest ETF in the group, with $7.85 billion in assets, giving it economies of scale that enable SSgA to run it more cheaply.

RYF and RWW, meanwhile, cost twice as much as XLF even though they pull securities from the same universe, providing clear evidence that tweaks to weighting strategies can have a significant impact on trading costs.

In fact, all funds employing alternative-weighting strategies have expense ratios that are more than twice that of XLF. That's tracking error that takes away from their returns.

What's Behind The Performance Deviation?

The tilt toward relatively smaller-cap companies in an equal-weighting methodology, such as in Rydex's RYF, exposes a portfolio to higher-beta financial firms whose returns outpaced those of larger, more diversified financial firms in the period of study.

To be precise, small-cap financial firms had little to no exposure to European sovereign debt issues, and were therefore insulated from the large sell-off last summer.

However, the PowerShares PFI had the worst performance during the period. On the surface, that might seem surprising, because PFI uses a variation of equal-weighting, and thus shares the smaller-cap tilt of the simply equal-weighted RYF.

That underperformance can be explained by the fact that although PFI employs a modified equal-weighting methodology, the index's proprietary ranking system resulted in a fund that had a 75 percent value bias, and a weighting toward insurance firms that was well in excess of either FXO's or RYF's.

As the chart below shows, PFI's portfolio has a price/earnings ratio that's less than half that of RYF. It's this clear contrast in style tilts and sector weightings that drove the wedge between the performance of PFI and that of the two other leading equal-weighted funds in the segment.

Banking Insurance Investments REITs Real Estate Operations Non-Financials
XLF 48% 24% 18% 4% 2% 4%
FXO 18% 46% 18% 7% 4% 7%
RWW 46% 40% 11% 1% 1% 1%
RYF 29% 27% 22% 9% 2% 11%
PFI 22% 56% 15% 0% 3% 4%

Interestingly, the revenue weighting strategy of RWW caused the ETF to tilt larger than even the market-cap-weighted XLF. Again, size tilts don't tell the whole story, as the fund had a slight growth bias relative to XLF, which, as we've seen, performed better in the period studied.

The table below reveals that the equal-weighting strategy of RYF produced the group's best "information ratio," a measure of risk-adjusted returns. RWW managed to post the second-best risk-adjusted returns of the group, reinforcing the idea that simple tweaks to the same universe can enhance performance given the ideal market environment.

FXO PFI RWW RYF XLF
Information Ratio 12 months 6.738% 2.925% 7.001% 12.396% 2.009%
P/E Ratio 15.81 12.03 18.32 25.82 16.80
Average Market Cap ($US M) $12,624 M $10,449 M $83,635 M $23,108 M $80,200 M

On the other hand, the relatively low information ratios of XLF and PFI reveal the weaknesses of the two funds' weighting methodologies. The large tilt of XLF exposed the portfolio to the largest multinational banks in the segment. It was in the past two years that these banks had to deal with both the fallout from the subprime crisis and the European sovereign debt mess.

Since the period of study was one filled with such unique market-moving events, it's difficult to draw any concrete conclusions about how different weighting methodologies will impact performance moving forward. Only time will tell.

But for now, if the market keeps rising and growth continues to outpace other investing styles, simply equally weighting your portfolio will help you reap outsized rewards.

Don't forget to check IndexUniverse.com's ETF Data section.

Copyright ® 2011 Index Publications LLC . All Rights Reserved.



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: FXO , PFI , RWW , RYF , XLF

IndexUniverse

IndexUniverse

More from IndexUniverse:

Related Videos

Form 990 Explained
Form 990 Explained                  

Stocks

Referenced

Most Active by Volume

128,306,232
  • $60.84 ▼ 0.85%
89,644,283
  • $3.195 ▲ 0.79%
69,138,516
  • $16.34 ▼ 0.18%
67,996,983
  • $4.35 ▼ 1.58%
45,833,963
  • $87.59 ▲ 0.96%
40,667,300
  • $46.28 ▼ 2.42%
38,947,294
  • $26.16 ▼ 0.34%
38,107,217
  • $39.86 ▲ 0.43%
As of 4/24/2014, 04:04 PM