This article was written by Invesco PowerShares Vice President, ETF Product Management, John Feyerer.

The core belief that we have held at PowerShares since we were founded back in 2002, and continue to hold today, is that funds tracking market-capitalization-weighted indexes may not represent the optimal investment strategy.  Why? If one believes (as we do) that markets aren’t perfectly efficient and security mispricing can and does exist, market-capitalization-weighted indices will, by definition, have overweighted those securities that through time proved to be overvalued and similarly will have underweighted those securities that proved to be undervalued — thus creating a relative drag on investment performance.  Of course the quest for active managers is to accurately identify which camp each security falls into at a given point in time (overvalued versus undervalued) and position portfolios to capitalize on the reversion to the mean. 

In contrast, smart beta strategies are objective, rules-based, index methodologies that sever the link between price and portfolio weight and employ a disciplined rebalancing mechanism.  From there a lot of fun can be had talking about the different risk factors that can serve as the basis for these methodologies, but it is important to remember the two basic ingredients that lie at the core of all smart beta strategies:  weighting by non-price-related measures and systematic rebalancing.

‘Naïve’ doesn’t necessarily mean balanced

The simplest of smart beta methodologies is widely accepted to be equal weighting.  This technique is commonly referred to as ‘naïve’ as it entails allocating the same weight to each constituent in the index and regularly rebalancing back to base weights.  Why is this approach described as ‘naïve’?  Because it does not make any assumptions about the index constituents (their size, prospects for future return, etc.) but instead simply weights them all equally.  While traditional equal weighting certainly contains the basic ingredients of smart beta –non-price-weighted and systematically rebalanced — it also introduces static sector biases since the weight allocated to each sector is determined solely by the number of companies in the sector.  For example, if an index contains 100 financial stocks and 50 technology stocks, the portfolio weight in financials would be double that of technology, regardless of the relative size between the two sectors.

The number of companies in a given sector alone is unlikely to be related to the relative prospects of that sector versus others, yet a simple constituent equal-weight strategy will statically allocate more (in some cases substantially!) weight to some sectors than others for the arbitrary reason of the difference in the number of constituents.  For example, as seen in Figure 1, the constituent equal-weight approach employed in the S&P 500 Equal Weight Index results in significant sector concentration, with three of the 10 sectors (financials, consumer discretionary and industrials) consistently comprising between 44% and 47% of the weight of the portfolio during the last 10 years.  In fact, in some cases constituent equal weighting can introduce greater sector-specific risk than capitalization weighting, as demonstrated by Figure 2.  If one were to take a constituent equal-weight approach to the Russell 1000 Index, that would result in an allocation of 22.2% of the portfolio to the financial services sector versus just 4.8% to consumer staples — a spread of over 17%.

An alternative to constituent equal weighting is the approach that Russell Indexes takes with its Russell 1000 Equal Weight Index. The firm initially equally weights the sectors (at each quarterly rebalance 11.1% is allocated to each of the nine sectors within the Russell Global Sector classification system) and then follows that by equally weighting the constituents within each sector.  This results in a portfolio that we believe is both “naïve” from a sector and constituent level and helps mitigate the sector biases inherent in a constituent equal-weight approach.  This methodology also enables the index to contra-trade against the most recent price movements at the sector level as well as at the constituent level as the index rebalances.

While clearly aligning with the basic elements of smart beta – the traditional equal-weight approach may not be as diversified as many investors think, and it may, in fact, be introducing unintended sector-specific risk to an investment portfolio.  Employing sector equal weighting followed by constituent equal weighting in the rebalancing process is an approach that we believe ultimately results in a better way to distribute risk across the portfolio.

Accessing sector equal-weight ETF strategies

After discussing the merits of a sector equal-weight strategy with their advisors, investors may want to consider it to help manage sector-specific risk and more broadly diversify the US equity portion of their investment portfolio.  The PowerShares Russell 1000 Equal Weight Portfolio (EQAL) is based on the Russell 1000 Equal Weight Index.  EQAL was incepted on Dec. 23, 2014 – for more information on this exchange-traded fund please click here.