Diversify Risk with an Equal-Weight Stock ETF | ETF Trends

As investors look to alternative index-based strategies to gain an edge in the markets, some have turned to equal-weight ETFs to access equities.

Equal weighting assigns equal representation to each index component and is one of the oldest and most time-tested alternative indexing methodology to deviate away from traditional market-capitalization weighting, providing investors with diversification and other risk-mitigating benefits.

“Equal-weighted indexes are one of the earliest examples of “smart beta” indexes. They have long been popular for their ability to diversify the mega-cap dominance inherent in cap-weighted indexes. Likewise, rebalancing to equal-weight causes the index to increase the weight of stocks that have recently declined and decrease the weight of stocks that have recently risen. This contrarian trading pattern (‘buy low, sell high’) is a key component of the equal-weighting methodology,” according to a FTSE Russell research note.

Due to the way they are constructed, equal-weight index funds are typically more diversified than their cap-weighted counterparts. Investors would be able to gain greater exposure to the historically higher premium of midcap stocks.

However, just equally weighting the underlying constituents does not necessarily provide diversification at the sector level, so equal-weighted indices may still have significant sector biases like their cap-weighted counterparts.

FTSE Russell methodology

The FTSE Russell methodology, though, tries to eliminate this risk of equal-weighting sectors. Specifically, the Russell 1000 Equal Weight Index differs from simple constituent-only approaches to provide less volatility, more downside cushion during a crisis and a strong long-term performance record.

The Russell 1000 Equal Weight Index’s enhanced sector-weight diversification methodology diminished the volatility of traditional constituent equal-weighting that comes from the increased exposure to midcap stocks.

The index has provided downside protection over time, with smaller drawdowns than both its cap-weighted and constituent-only equal-weighted counterparts during the dotcom bubble bust and global financial crisis. Furthermore, Russell 1000 Equal Weight Index took less time to fully recover.

Additionally, the enhanced diversification has enabled the Russell 1000 Equal Weight Index to outperform the cap-weighted and a hypothetical constituent-only equal-weight index over the long term.

Investors who are interested in gaining exposure to this equal-weight methodology can look to the Invesco Russell 1000 Equal Weight ETF (NYSEArca: EQAL), which is based on the Russell 1000 Equal Weight Index.

The ETF’s index methodology 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.

For more information on the equal-weight indexing methodology, visit our equal-weight ETFs category.