Investors who are seeking to build out a diversified long-term investment portfolio should consider enhancing returns through equally weighted exchange traded funds.
Researchers led by Timo Pfeiffer, Head of Research & Business Development at Solactive, found that equally weighted portfolios outperform market cap weighted ones over a period of evaluation running from 2000 to 2017, falling more during bear markets but recovering faster after downturns, according to a recent Solactive AG research paper.
“Our study shows that the most important driver of the equally weighted portfolio’s outperformance is the higher exposure to small cap stocks. Therefore, although stock size is not taken into consideration with equally weighted strategies, it is actually the most important factor in explaining their outperformance over market cap weighted portfolios,” according to Solactive AG.
Over the test period of February 2000 through October 2017, equally weighted portfolios outperformed market-cap weighted indices, exhibiting higher systematic risk but a faster recovery time. In other words, while equally weighted indices may exhibit greater risk during drawdowns, they were faster to recover and outperform in rebounding conditions.
The researchers found that equally weighted portfolios provide better diversification and diminish unsystematic risk or lower overall concentration risk in a traditional market cap-weighted investment portfolio. This makes sense since equally weighted indices and related ETFs generally lean toward mid- and small-cap companies.
However, due to its indexing methodology and greater tilt toward smaller companies, equally weighted index funds display higher risk values. The small company tilt, though, still allows the strategy to capitalize on the overall outperformance of smaller sized companies over the long haul, which has been documented through historic data and academic studies.
Furthermore, there is an innate buy low and sell high type of feature embedded in an equally weighted index. The better returns of an equally weighted strategy is partially explained by the rebalancing effect where stocks are brought back to equal weight by buying low and selling high – outperforming stocks tend to gain in market capitalization so they are sold and the money is then used to buy into underperformers with lower market-caps to bring the equal weight indexing methodology back in line.
ETF investors interested in gaining exposure to an equal-weight indexing methodology may look to something like the recently launched Goldman Sachs Equal Weight U.S. Large Cap Equity ETF (BATS: GSEW), which also comes with a low 0.09% expense ratio.
The Equal Weight U.S. Large Cap Equity ETF tries to reflect the performance of the Solactive US Large Cap Equal Weight Index, which consists of about 500 of the largest U.S. companies and equally weights holdings so that each component is approximately 0.2% of index on rebalance.
Additionally, the Guggenheim S&P 500 Equal Weight ETF (NYSEArca: RSP), which tracks the S&P 500 Equal Weight Index, is the largest equal weight-oriented ETF. The underlying S&P 500 Equal Weight Index is the equal weight version of the S&P 500 Index. The equal-weight index contains the same component holdings as the cap-weighted S&P 500, but each company in the S&P 500 Equal Weight Index is allocated the same weight at each quarterly rebalance. Consequently, the holdings are balanced across all of the S&P 500 companies evenly over time.