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.