Proponents of equal-weight ETFs, which hold equal allocations of each portfolio holding, will argue that their version of indexing can be more advantageous because owning greater proportions of a range of market capitalizations means better diversification and higher returns in the long run.
For example, the top holding in one of the oldest and most-traded ETFs in the world, the SPDR S&P 500 ETF (NYSEArca: SPY), is market cap leader Apple (NASDAQ: AAPL), which represents 3.62% of the portfolio.
Compare that to the holdings of an equal-weighted ETF like the Guggenheim S&P 500 Equal Weight ETF (NYSEArca: RSP). The top holding is SanDisk Corp. (NASDAQ: SNDK), which represents 0.27% of the portfolio. Most of the other holdings in RSP are very close to that allocation.
Pros of Equal-Weight ETFs
- Equal allocation of holdings reduces overall market risk by minimizing exposure to one market cap.
- There’s more upside potential, primarily due to higher concentrations of small- and mid-cap stocks, as compared to cap-weighted index funds.
- With periodic rebalancing, equally weighted funds tend to lock in gains by selling shares of the short-term winners and buying more shares of the losers, which is generally smart for investors to do anyway.
Cons of Equal-Weighted ETFs
There are also some disadvantages of equal-weight ETFs to keep in mind:
- Funds with higher relative exposure to smaller capitalization stocks tend to be more volatile in the short term, which means bigger drops in price during market corrections.
- These ETFs are relatively new on the market and therefore trade at lower volumes, which can lead to larger bid-ask spreads, larger discrepancies between net asset value and the value of the underlying securities, and therefore a decreased ability to trade profitably.
- Equal-weight ETFs tend to charge higher expenses than cap-weighted ETFs and index funds.
Should You Buy Equal-Weight ETFs?
Equal-weight ETFs can be a smart choice if used properly. For example, if you want an aggressive core holding, these funds can be a solid foundation to build a diversified portfolio. But be careful not to think of equal-weight ETFs as an even swap for cap-weighted index funds.
For more portfolio and performance comparison between cap-weighted and equal-weighted ETFs, we can look more closely at the SPY and RSP funds:
- The SPY portfolio has an average market capitalization of $68.4 billion, whereas RSP has an average market cap of $19.9 billion.
- The expense ratio for SPY is a rock-bottom 0.09%, but expenses for RSP are 0.40%.
- The 10-year annualized return for SPY is 7.9%, which compares to 8.9% for RSP.
This comparison is typical of cap-weighted versus equal-weighted ETFs with similar objectives.