Why Equal Weight ETFs are Outperforming This Year

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August 30, 2016 2:24pm NYSE:RSP

From David Fabian: The first indexes to ever grace the field of exchange-traded funds were all market-cap weighted baskets.  This structure gives the largest share of assets to the stocks with the biggest outstanding share floats. In many ways this makes sense, because it provides investors with the same distribution of wealth that market prices have already factored in.


This is the reason why Apple Inc (AAPL) is the largest holding in the market-cap weighted SPDR S&P 500 ETF (SPY) at 3.09%.

In the pervasive quest to outperform these well-known benchmarks, the concept of equal weight indexes was introduced.  An equal weighted methodology takes a certain number of stocks and gives them a similar distribution of invested capital.  The net effect is to diminish the importance of larger stocks and enhance the contributions of smaller companies.  Think of it as leveling the playing field for all securities in the underlying basket.

The most storied fund in this category is the Guggenheim S&P 500 Equal Weight ETF (NYSE:RSP), which debuted in 2003.  RSP takes the same 500 stocks in SPY and proportions them equally.  Each ticker symbol that drives the returns of RSP garners approximately 0.20% of the total asset base, which currently stands near $10 billion.

This has proven to be a meaningful driver of diverging returns over various market cycles.  Not surprisingly, RSP tends to outperform when small and midcap stocks lead.  Conversely, during periods of large-cap strength, this fund will relinquish its relative advantage to the traditional benchmark.

The obvious takeaway for ETF investors is that, not only does security selection and fees play an important role in net returns, but so does the overall index weighting methodology.  The more concentrated a fund is towards a small group of stocks, the greater emphasis will be placed on those companies to adequately perform.

This leads to an interesting phenomenon that many investors may not even have considered – that the funds you own now may already be using an equal weight approach.  Many smart beta indexes and even sector funds are constructed using these parameters.

For example, the beloved PowerShares S&P 500 Low Volatility ETF (SPLV) identifies 100 stocks in the S&P 500 Index with the lowest historical price volatility over the last twelve months.  The fund then equal weights all of the final components and rebalances them on a quarterly basis.  SPLV has over $7.6 billion in total assets and has become a favored landing spot for conservative investors over the last several years.

Another popular option that implements an equal weight approach is the First Trust Dorsey Wright Focus 5 ETF (FV), which has $3.1 billion under management.  This ETF screens sector and industry ETFs for top momentum characteristics and then adds the five highest ranking groups to its portfolio.  Each underlying sector fund is proportionately allocated with 20% of the fund assets.

Dividend growth investors may covet the ProShares S&P 500 Dividend Aristocrats ETF (NOBL) as ahidden opportunity in the equal weighting category. NOBL selects stocks from the S&P 500 Index that have increased dividends on an annual basis for at least 25 consecutive years.  There are currently 50 stocks with this distinction, which are all aligned with a similar 2% distribution of capital in the portfolio.

Lastly, this distinctive style can be applied to sector and industry-based ETFs as well.  The SPDR S&P Oil & Gas Exploration & Production ETF (XOP) and SPDR S&P Bank ETF (KBE) both subscribe to a modified equal weighting system.  This helps reduce the burden of large stocks having a disproportionate allocation within a focused niche of the economy.

The Bottom Line

The aforementioned funds are just a few pertinent examples of popular ETFs with embedded equal weight index construction criteria.  There are also many other funds that utilize this methodology as well.  Uncovering this attribute is as easy as visiting the fund company’s website and clicking on the current holdings or reading about how the index is created.

Knowing how the underlying holdings are allocated is a critical component of evaluating and selecting an ETF that meets your needs.  These factors are an important driver of risk and return during the time you own the fund.

This article is brought to you courtesy of FMD Capital Management.


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