While weighting by market cap in exchange traded funds (ETFs) is by far the most common method, there are other types of weighting that tend to perform better in certain economic conditions.
Take, for example, equal weighting. Although it’s a lesser-used method than market-cap weighting, it’s no less effective when the timing is right.
What It Is
Equal weighting is a construction method where each stock is balanced out in an equal-weighted index so that even the smallest company is given the same weight as the largest company.
The Standard & Poor’s 500 Equal-Weight Index and the Wilshire 5000 Equal-Weight Index are examples of the indexes that employ the equal-weight methodology. Rydex|SGI, First Trust and ALPS have some equal-weight ETFs, including:
- Rydex S&P Equal Weight (NYSEArca: RSP)
- First Trust NASDAQ-100 Equal Weight (NASDAQ: QQEW)
- ALPS Equal Sector Weight (NYSEArca: EQL)
Each index would assign the same weightings for the securities that the index tracks. For instance, an equally-weighted S&P 500 ETF, such as RSP, would give a 0.2% weighting for each of its 500 components. Rebalances are conducted each quarter to adjust for changes in market values.
The Impact of Equal Weighting
Giving all stocks in an index the same weight has an undeniable impact.
The biggest impact comes as a result of evening out the playing field: because no company holds more sway than another, equal weighting gives mid- and small-cap stocks a chance to shine. This fact serves equal-weighting best in periods of economic recovery, when small-caps tend to outperform. Case in point: RSP is up 10.9% year-to-date, while the S&P 500 is up 4.5%.
Additionally, equal-weighted indexes may also avoid excessive valuations in momentum-driven environments. In other words, no company gets too big for its britches in an equally-weighted index.