Michael Johnston: In the universe of equity ETFs, market capitalization weighting strategies are incredibly dominant. The majority of the hundreds of domestic and international stock ETFs available to U.S. investors are linked to cap-weighted benchmarks, and the lion’s share of assets is in products that utilize this well known methodology. But in recent years, thanks in part to the ETF boom, alternative weighting methodologies have been gaining traction. For those seeking to steer clear of cap-weighting and all of its potential drawbacks, equal weighting has emerged as a popular alternative.
Part of the appeal of this approach may lie in the apparent simplicity; instead of giving the biggest allocations to the most valuable components of an index, equal weighting generally involves assigning an equivalent allocation to each security that meets the membership requirements for the benchmark. Breaking the link between stock price and index weight eliminates concerns that often are attached to cap-weighted ETFs, and the disciplined rebalancing that the equal weight approach forces can be an efficient way to reallocate holdings within a rules-based framework [see Equal Weight ETFdb Portfolio ].
There are a number of equal-weighted ETFs now on the market, some of which have become tremendously popular. And while the general investment philosophy between these products is similar, there are some nuances that differentiate these products [for more ETF insights, sign up for the free ETFdb newsletter].
1. Equal Weighting Stocks
Many equal weight ETFs, including the $2.6 billion Rydex Equal Weight S&P ETF (NYSEARCA:RSP), simply assign equal allocations to each component security. For RSP, which holds the 500 stocks that make up the S&P 500, that means a weight of about 0.2% to every name in the index. For benchmarks with considerably more securities, the concentration can be even less significant; the MSCI Emerging Markets Equal Weight Index assigns a weighting of close to 0.1% to each of its component securities.
ETFs that implement this version of equal weighting strategy tend to have a heavier allocation in small cap and mid cap ETFs than their cap-weighted counterparts.
2. Equal Weighting Sectors
There is another twist on equal weighting that has made its way into the ETF wrapper: assigning equal weights to sectors of the economy. Many broad-based equity ETFs–both domestic and international–tend to maintain portfolios that are far from balanced from a sector perspective. Though the exact allocations can vary significantly, it is generally sectors such as energy, financials, and materials that receive the largest allocations while utilities, health care companies, and telecom stocks tend to be relatively underweighted.
The ALPS Equal Sector Weight ETF (NYSEARCA:EQL) takes a unique approach to domestic equity exposure; each of the nine major sectors of the U.S. economy receive an equivalent allocation. This approach might be appealing for a couple of reasons; it prevents establishing big allocation to sector-specific “bubbles” (a strategy that would have paid big dividends in the early 2000s) and also allows investors to participate in rallies in corners of the economy that are not always well represented in traditional equity products [see Time To Dump SPY?].
It should be noted that this version of equal weighting does not necessarily deliver equal weights at the individual stock level; because EQL’s holdings actually consist of sector SPDRs, this fund can be thought of as a blend between market cap weighting (at the individual stock level) and equal weighting (at the sector level).
1 + 2 = Rydex Russell ETFs
There are a couple of products on the market that combine both aspects of equal weighting, ensuring that investors achieve exposure that is balanced from a sector perspective while also avoiding concentrations in any individual components. A trio of Rydex ETFs linked to equal weight Russell indexes fit this description:
- Rydex Russell 1000 Equal Weight ETF (NYSEARCA:EWRI)
- Rydex Russell 2000 Equal Weight ETF (NYSEARCA:EWRS)
- Rydex Russell Mid Cap Equal Weight ETF (NYSEARCA:EWRM)
Each of these three funds are linked to indexes that apply a multi-level equal weighting approach; the nine sectors are equal weighted, and then each stock within those sectors receives an equivalent weighting. So some stocks receive a larger allocation than others in different sectors, but both cap weighting and sector tilts are avoided entirely.
There is no universally superior methodology here; certain approaches will work well in certain environments, while others will end up being optimal in others. In some cases, simple cap weighting will beat all of the various forms of equal weighting; amidst the heightened volatility of recent months, the simple market capitalization weighting approaches have performed quite well. But the option to choose from these various techniques should be quite appealing to investors; the current lineup of ETFs allows for impressive precision even within specific asset classes.
Written By Michael Johnston From ETF Database Disclosure: No positions at time of writing.
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