4 Benefits of Equal-Weighted ETFs

In a recent blog post, I discussed how investors can potentially improve their core equity exposure—in terms of diversification and the potential for generating alpha—by implementing sector investing.

We have seen investors increasingly use Industry ETFs in addition to sectors to gain more targeted exposure and amplify the drivers of sector growth. But it’s important to evaluate Industry ETFs with a close eye. Two indices tracking the same industry can look alike at first glance, but different approaches to index construction can result in material deviation in how the index is composed and, ultimately, performs over time.

The SPDR® ETF Industry lineup follows the S&P® Select Industry Indices, which use a modified equal weighting approach. By applying an equal weight to each stock in the index, the underlying exposure reduces stock-specific risk and provides deeper market cap segmentation to large-, mid-, and small-cap firms.

Other popular industry indices use the more traditional market capitalization-weighted methodology. But market cap-weighted indices have the potential to increase portfolio concentration when targeting a narrow market segment like sector sub-industries.

To understand how differences in methodologies can give rise to markedly different exposures, let’s compare two seemingly similar ETFs that track the Biotechnology Industry: SPDR® S&P Biotech ETF [XBI] and iShares Nasdaq Biotechnology ETF [IBB].

While the index that IBB tracks weights constituents by market cap, XBI uses a methodology where all stocks are equal-weighted. Historically, this has demonstrated four potential benefits:

1. Lower concentration and less skew in risk toward top index holdings

Weighting constituents by market cap can translate to high concentrations in an ETF’s largest securities. As illustrated by the “Concentration Analysis” graph below, though IBB has more securities, its Top 10 holdings make up 58% of the portfolio (versus only 11% for XBI).1 As a result, IBB’s risk is skewed toward the concentration in Top 10 holdings.

Source: State Street Global Advisors, Bloomberg, as of 6/30/2015.

The lower stock-specific risk for XBI can allow the broader industry to drive returns, as opposed to a handful of particular stocks.

2. Deeper market cap segmentation offers broader industry coverage

As market cap-weighted indices assign the largest weights to those securities with the greatest market values, it stands to reason that these indices would exhibit an inherent large-cap bias. The “Market Cap Segmentation” chart demonstrates that this is the case when comparing XBI and IBB. While 21% of IBB’s holdings are mid- and small-cap securities, 80% of XBI’s securities are mid- and small-cap.2

Source: State Street Global Advisors, Bloomberg, as of 6/30/2015.

With a broader representation across market capitalizations, XBI can offer greater diversification and deeper market breadth to the entire industry within the US market.