The Ins and Outs of an Equal-Weighted ETF

March 6th at 12:40pm by Tom Lydon

Exchange traded funds typically track an index that is weighted by market capitalization, but some funds are led by an alternative method. The goal of an equal-weight strategy is to limit the amount of exposure a larger, more popular stock can contribute in an effort to limit over-allocation within a portfolio.

“The market has a nasty tendency of over-relying on the good companies and paying too large a premium [for them] on the tacit assumption that recent success portends long-term future success,” Rob Arnott, CEO of investment firm Research Affiliates LLC, said in a recent MarketWatch report. The firm’s RAFI indexes are tracked by several exchange-traded funds from provider Invesco PowerShares that rate stocks based on financial strength and other fundamental corporate measures. [Why an Equal-Weight S&P 500 ETF is Outperforming]

Fans of the equal-weight indexing approach appreciate it for the idea that a smaller, up-and-coming company can be have just as much allocation within an ETF as a large-cap, blue chip stock. In turn, this modifies the losses that can occur when a single stock takes a hit, reports Jonathon Burton for MarketWatch. [Best ETFs for Equal-Weighted Strategies]

The run-up in Guggenheim S&P 500 Equal Weight (NYSEArca: RSP) has supported the merit of an equal-weight strategy. RSP outperformed the SPDR S&P 500 (NYSEArca: SPY) by an entire percentage point over the past 3 years, and by two points over the past 5 years, reports Burton. [How Equal-Weight ETFs can Protect a Portfolio]

Investors should not be too quick to switch to an equal-weight strategy without considering the risks. Equal-weight strategies can cause over-allocation or under-allocation to certain areas of the market, since the portfolios re-balance on a quarterly schedule. The value approach tends to sell winning stocks and buy lagging stocks, which is attractive for bargain hunters. The constant re-balancing, however, means that the ETF must be monitored regularly to avoid over-exposure to a particular company.

Also, since equal weighting in an index tends to favor small- and mid-cap stocks which can be more volatile than established large-caps, the amount of uncertainty can be heightened should the market take a downturn.

“You may be reducing your exposure to giant megacaps, especially when they reach bubble territory, but you’re also dramatically increasing your exposure to small and midcap stocks, which tend to be more volatile,” says Samuel Lee, an ETF analyst at investment researcher Morningstar Inc. “There’s no free lunch.”

One last point of caution: the ETFs that use an equal-weight strategy tend to be more expensive than a traditional market-cap weighted fund.

Guggenheim S&P 500 Equal Weight

RSP, SPY, Indexing, Equal-Weight ETFs, ETF,

Tisha Guerrero contributed to this article.

Full disclosure: Tom  Lydon’s clients own RSP and SPY.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Mr. Lydon serves as an independent trustee of certain mutual funds and ETFs that are managed by Guggenheim Investments; however, any opinions or forecasts expressed herein are solely those of Mr. Lydon and not those of Guggenheim Funds, Guggenheim Investments, Guggenheim Specialized Products, LLC or any of their affiliates. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

Tickers

RSP SPY