Just as not all exchange traded funds (ETFs) are created alike, not all indexes are cut from the same cloth. The differences between indexing methods can have a real impact on your returns, so let’s study up.
Over the past year, ETFs using equal- and revenue-weighted methods actually outperformed market cap-weighted funds, which is the most common method of indexing. Equal-weighted ETFs are just as they sound: every stock in the index has the same weight, regardless how large or small the company is, reports Zignals on Benzinga. [What About Quant ETFs?]
A market cap-weighted index, in contrast, uses the share price multiplied by total shares outstanding. Therefore, the returns of large-cap stocks in the index play a much greater role in the overall index performance than small caps.
Equal weighting gives two primary benefits:
- Equal weighting tends to do well in periods during which small-caps outperform (typically in periods following recessions).
- Equal weighting is a play on the belief that the markets always revert to the mean, since when you’re rebalancing, you’re selling winners and buying losers. [Benefits of Equal Weight VS. Revenue-Based.]
The largest equal-weight ETF by far is Rydex S&P Equal Weight ETF (NYSEArca: RSP), which has $1.8 billion in assets under management. Ken Hawkins for Investopedia points out that it’s interesting to compare RSP with the SPDRs (NYSEArca: SPY) to see how an equal-weight and market-cap weighted ETF stack up against one another.
In the last six months, RSP has come out ahead, but they’re both down: RSP has lost 2.5% in that time, while SPY is down 4.2%. In the last year, RSP has fared better, gaining 12.7% vs. SPY’s gain of 6.9%.
It’s not always the case the one indexing type will outperform another. Certain economic conditions simply favor different indexing methods and different times, so don’t forget to factor this in when you’re choosing ETFs.
Tisha Guerrero contributed to this article.