The Truth About Alternative Weighting Methodologies; And ETFs (RSP, SPY, RWL, F)

Michael Johnston: As indexes have been essentially transformed into investable assets in part because of surging interest in ETFs, many advisors and investors have begun to take a closer look at the details of the methodologies behind the construction and maintenance of these benchmarks. Cap weighting, where the largest weights are afforded to the largest companies, has remained by far the most popular option–thanks in no small part to the low costs and low maintenance requirements associated with this approach. But alternative weighting strategies have been growing in popularity as well, emerging as opportunities to generate excess returns by simply tweaking the manner in which weights are assigned to individual securities [see also The Ten Commandments of Commodity Investing].

There has been a significant amount of debate on the merits of these weighting methodologies, including at a panel last month at the Inside ETFs Conference presented by Index Universe. Many view the alternative weighting methodologies (meaning anything that is not market cap weighting) as simply a better way to index, thanks to the ability to break the link between stock price and security allocation. There is another school of thought that the various alternative weighting methodologies out there are simply ways of tilting exposure towards various “factors” such as value or leverage. Below, we run through some of the popular alternative weighting methodologies out there from a different perspective: the tilts that result from the nuances of the underlying strategy [for more ETF insights, sign up for the free ETFdb newsletter].

Equal Weight = Small Cap

Equal weighting methodologies have drawn increased interest in recent years, thanks in part to the impressive performance of the Rydex S&P Equal Weights ETF (NYSEArca:RSP) relative to the S&P 500 SPDR (NYSEArca:SPY). Though both ETFs hold the same 500 stocks, RSP has fared much better for the last several years.

The appeal of RSP lies in the opportunity to break the link between weight and stock price, thereby avoiding what some argue is an embedded inefficiency in this methodology. But there is another way to think of equal weighting: as a shift towards smaller companies. RSP, for example, has a considerably larger allocation to mid cap stocks than does SPY, since the weightings to the stocks with the largest market caps are limited. The focus on smaller companies generally means greater volatility on both the up side and down side; that relationship has certainly played out between RSP and SPY [see also RSP vs. SPY: 2011 At a Glance].

Equal weighting can also be thought of as having a contrarian or anti-momentum tilt, since allocations are brought back to the “base weight” upon rebalancing. That effectively means that weightings in the best performers are reduced, with the proceeds used to purchase shares of stocks that have struggled recently.

Dividend Weight = Value Stocks

Dividend weighted ETFs have also seen increased interest over the last year, emerging as one effective tool for investors looking to enhance current returns and reduce risk. Dividend weighting can also be thought of as a way of implementing a value tilt, since this approach will generally result in a larger weighting to value stocks than a cap-weighted approach. Growth companies that are reinvesting capital will be given a relatively small weight compared to stocks that make hefty payouts. So it shouldn’t be surprising that dividend-weighted ETFs will perform well when value stocks are outperforming but may struggle in environments where growth stocks have the edge [see Dividend ETF Special: 25 ETFs With Juicy Yields].

It should also be noted that dividend-weighted indexes (as well as dividend yield-weighted indexes) will exclude stocks that do not make distributions. In some cases, that means missing out on impressive returns; AAPL, which has skyrocketed in recent years, won’t be found in any dividend-weighted ETF [see also 12 High-Yielding Commodities For 2012].

Revenue Weight = Low Margin, High Debt Companies

While the tilts delivered by the weighting approaches highlighted above may be rather obvious, the ramifications of revenue weighting–where allocations are determined by top line sales–may not be so clear. Relative to cap weighting, this methodology will tend to overweight stocks with thin profit margins (as well as those operating at a loss), since higher earnings (which generally lead to a higher market cap) have no impact on weighting methodology. This explains in part why Ford Motor Company (NYSE:F) is the fifth largest holding of the RevenueShares Large Cap Fund (NYSEArca:RWL) at 1.5% of assets, while the carmaker accounts for just 0.4% of SPY (and is not even in the top 50).

Revenue weighting also tends to introduce a shift toward companies with higher debt-to-equity ratios, since the impact of interest expense is non-existent–only top line revenue matters. Because the equity value (i.e., market cap) can be calculated by deducting debt from overall enterprise value, cap weighted benchmarks would generally give higher weightings towards a company with low debt, all else being equal. Revenue weighting shifts exposure towards companies with higher leverage, which can result in strong performances in bull markets but cause problems when markets fall [see also Three Reasons Why Gold Is Overvalued].

RAFI Weight = Value Stocks

The RAFI methodology developed by Research Affiliates has become quite popular in recent years, and the company has teamed up with multiple ETF issuers to develop products that utilize this approach to security weighting. Rather than relying on one fundamental factor, RAFI weighting uses four: book value, cash flow, sales, and dividends. While many view RAFI indexes as an enhanced beta, it’s also reasonable to see this strategy as another way of tilting exposure towards value stocks and low margin companies, since this approach incorporates two of the factors outlined above [see Do You Need A RAFI ETF?].

The More The Merrier

Ultimately, there is no universally superior weighting methodology that holds the secret to excess returns. Cap weighting will perform well in certain environments, while equal weighting will lead the way in others. The same can be said for all the other strategies out there; dividend-weighted ETFs enjoyed a banner 2011 as interest in stocks offering meaningful current returns surged.

The choice of weighting methodology is a very important one that has the potential to have a major impact on bottom line returns. But keep in mind that weighting methodologies essentially reflect a tilt towards one factor another, whether it be small cap stocks, value stocks, or leveraged stocks. There are environments in which each of those methodologies will perform well, and others in which they will struggle [see also ETFs For The Capital Preservationist].

Written By Michael Johnston From ETF Database Disclosure: No positions at time of writing.

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