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.The key takeaway is that the higher exposure to small- and mid-cap stocks in equal-weight ETFs tend to give a performance edge, especially for long-term returns.
Therefore, investors may need to be patient to see results with equal-weight ETFs.
The added exposure to the more aggressive stocks in equal-weight ETFs also needs to be factored into an investor’s diversification strategy.
Before buying equal-weight ETFs, be sure to make any necessary adjustments to other holdings in the portfolio, such as small-cap and mid-cap ETFs.
Kent Thune is the owner of an investment advisory firm in Hilton Head Island, S.C. He personally does not hold any of the aforementioned securities. Under no circumstances does this information represent a recommendation to buy or sell securities.
This article is brought to you courtesy of Kent Thune from Wyatt Research.