Lawrence Meyers: The explosion of ETFs in the stock market has made broad market diversification easier than ever before. As an advocate for investors to build long-term broadly diversified portfolios, the availability of ETFs that cover every imaginable sector has made precise asset allocation a true reality. It has also created opportunities to build portfolios that have less volatility than the major indices.
For those seeking capital preservation and low volatility, particularly retired investors, there is a group of ETFs you must not overlook. They are not well-advertised, and are often passed over for sexier leveraged ETFs that provide multiples of any given index’s daily moves.
These are known as “equal-weight ETFs”.
They differ from the standard index-tracking ETF or mutual fund in that most index-tracking investments hold a basket of stocks based on the market capitalization of each stock in the index. Thus, the largest company in an ETF will also have the largest position. So if Google (NASDAQ:GOOG) has a market cap that is equal to 8% of the entire market cap of a given index, the ETF will buy enough Google so that it takes up 8% of the ETFs portfolio.
That’s what causes volatility in most ETFs. If a few stocks make up the majority of the portfolio, then moves in those few stocks moves the entire ETF.
However, if every stock holds an equal position with all the others, then they all must move together for the ETF to move a huge amount. This way, a small cap stock can have just as much influence on the ETF as a Google. The result is you still have exposure to a certain sector or asset class, but with reduced volatility.
With this, however, you may experience reduced returns. An equal-weight ETF may lag its market-cap-weighted peer on the upside, and may not lose as much on the downside. It depends. If lesser-known names have a huge rally one year while big-cap names falter, then equal weight ETFs may outperform on the upside, and vice-versa.
There are five equal weight ETFs I want to draw your attention to:
Guggenheim S&P 500 Equal Weight ETF (NYSE:RSP) gives you exposure to the entire S&P 500, but with each stock given equal weight. In this case, returns over all periods (YTD, 1-month, 3-month, 1 year, 3, year, 5 years) have outperformed the SPDR S&P 500 ETF (NYSE:SPY). YTD, for example, the RSP has returned 8.47% vs. 6.95% for SPY.