Equal Weight ETFs Can Juice Your Returns

new etfsDavid Fabian: When constructing a growth or income portfolio I always start with core positions that are the foundation for a diversified and balanced strategy. Core positions typically track established indices such as the S&P 500 or Dow Jones Industrial Average because they give you diversified correlation to the broader market. Then you can layer in some sector, industry or special situation funds to enhance the characteristics of your portfolio given the amount of risk you are willing to take.

Another way to juice the returns of your portfolio is to look for core positions that are outperforming their peers. This is exactly what equal weight ETFs have been doing for some time now.

ETFs that follow a market cap weighted index allocate the majority of their assets to the largest stocks in their portfolio. The largest stocks will therefore have an outsized pull on the performance of the ETF over time because of their higher concentration. These market cap weightings are typically rebalanced on a quarterly basis based on the size of the stocks in the index at the end of the quarter. For example, Apple (AAPL) is the largest holding in the SPDR S&P 500 ETF (SPY) with 2.80% of the total assets, while AutoNation Inc (AN) is the smallest holding with only a 0.01% share.

By contrast, equal weight ETFs allocate their portfolios equally across every stock in the index no matter what their fundamental characteristics may be. The Guggenheim S&P 500 Equal Weight ETF (RSP) has the same number of stocks as SPY but every stock in the ETF has between 0.15%-0.25% in weighting. The fund is rebalanced quarterly to adjust for stocks that underperform or outperform to bring each allocation back into equal balance. It may seem like the differences between these two strategies are minor, however the disparity in performance returns have been quite significant over time.

If you look at a one-year chart of SPY vs. RSP below you will see that the equal weight fund has outperformed its peer by over 7%. That is a noteworthy difference in total return over a one-year time frame.

Another stark example of equal weight outperformance over the last year has been the difference between the PowerShares QQQ (QQQ) and the First Trust NASDAQ-100 Equal Weight Index Fund (QQEW).

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