Investors seeking to break away from a top-heavy, market-capitalization-weighted index can take a look at a new breed of smart-beta exchange traded funds that equally weight components.
For instance, the ETFS Zacks Earnings Large-Cap U.S. Index Fund (NYSEArca: ZLRG) and the ETFS Zacks Earnings Small-Cap U.S. Index Fund (NYSEArca: ZSML) not only equally weight component stocks, but the two relatively new ETFs also equally weight sectors in an attempt to help provide greater diversification and better returns. [ETF Securities Expands Equity ETF Lineup With Two More New Funds]
These funds “won’t move in lockstep with market-cap -weighted indices,” Mitchel E. Zacks, Managing Director and Portfolio Manager at Zacks Investment Management, said in a phone interview. Specifically, Zacks notes that ZLRG and ZSML both allocate the same weighting in each sector and the equal-weight methodology could drive outperformance in both of the ETFs.
In contrast, traditional market-cap-weighted indices may be top heavy and overweight stocks and sectors that have been outpeforming. During a market collapse, these same areas will likely be the hardest hit, dragging on market-cap-weighted fund.
Zacks argues that the equal-weight methodology would have outperformed, or at least mitigate the pullback, in the event of a broad decline. The strategist singles out the financials as among the largest sectors in the S&P 500 and the area exhibits some of the greatest swings during volatile conditions.
The financial sector, which makes up 14.6% of the S&P 500, fell 1.3% Friday and was the second worst performing area of the day. The ETFS Zacks Earnings Large-Cap U.S. Index Fund, on the other hand, only allocates 6.75% to the financial sector.
Moreover, Zacks believes the industrial space will do well ahead as the sector benefits from low oil and continued economic growth. ZLRG includes 6.65% to industrial products, 6.75% to aerospace companies and 6.55% to transportation.
Mike McGlone, Director of Research at ETF Securities US, also believes that the quantitative model behind ZLRG and ZSML could also provide investors with added value. The two funds picks component stocks based on Zacks’ quantitative models through ranking and quality factors. The ETFs hold the highest ranking stocks that have the most significant positive changes in earnings estimates. Additionally, Zacks singles out non-cash components, or accruals, in each company’s reported earnings, selecting firms with the lowest sector-adjusted accruals. [A Small-Cap ETF That Targets Strong Earnings]
For more information on alternative index-based ETFs, visit our smart beta category.
Max Chen contributed to this article.