Most ETFs weight their company holdings by market capitalization. The combined wisdom of all the market's investors is tough to beat.
But that is what alternative weighting schemes attempt to do. Fundamental ETFs have gained a lot of attention from claims that they can outperform cap weighting with proprietary methodologies using financial ratios. But also very popular is equal weighting, which is transparent and inexpensive and helps to diversify. Unfortunately, it is also an arbitrary system which shifts exposure to smaller companies of the target index in a poorly controlled manner.
With equal weighting every company is owned in equal amounts, an arbitrary but simple rule. Thus the Rydex S&P Equal Weight ETF (AMEX:RSP) contains each S&P 500 company in equal amounts, unlike the actual S&P where the top 10 firms account for roughly 20% of assets and the bottom 10 less than 1%. Clearly this dampens individual company risk. If 500 stocks are owned in equal amounts, risk to the portfolio of failure of one company is about .2% (it strays a bit before occasional rebalancing), a far cry from the 1%-5% exposure to each of the top 10 holdings of the S&P 500.
Performance comparisons depend heavily on periods examined. If over the very long run equal-weighting slightly outperforms market cap, it should come as no surprise because smaller companies should outperform larger ones, according to economists. We make nothing of short runs where one weighting scheme may win, as equal weighting has done lately.
For us it is not at the major index level but rather at sub-indexes where dampening of individual company risk shines, because it is here that mega-cap companies skew results. Correlations are quite high inside an industry, so there is little danger of missing out on a fundamental move in the sector.
So investors should be quite pleased to have at their disposal nine ETFs which chop the S&P 500 by industry sector to allow fine tuning:
They go head-to-head against cap-weighted sector ETFs such as the Select Sector SPDRs line. The Rydex ETFs deliver substantial diversification of company-level risk which can be an issue in typical industry ETFs. Typically Rydex equal weight company holdings do not exceed 5%.
Equal weighting also creates various effects which one can consider perverse or attractive depending on the circumstances. In addition to causing the smallest of the large companies to predominate, true multinationals to fall into the minority, and liquidity can drop. Equal weighting also emphasizes more fragmented industries. For instance, financials rises in importance, and at least in recent years this meant much greater volatility.
For passive investors with small-cap holdings, equal weighting plays havoc with attempts to allocate seamlessly across company sizes. While its uniform holdings might seem tidy on its face, in percentage terms the shift to smaller cap is anything but uniform. The smaller the company, the greater the shift. Real dislocation will occur at the edge of the S&P 500, at the 501st company. This does not happen with cap weighted large, mid and small-cap funds. From the portfolio perspective, this is poor control of size shifting.
Another equal-weighted ETF is the First Trust NASDAQ-100 Equal Weighted ETF (NasdaqGM:QQEW), with annual fees of 0.6%. It is essentially a collection of large cap stocks which happen to trade on one US exchange, so it's less than ideal for cleanly allocating assets. The NASDAQ's propensity for high-tech companies with good liquidity make it useful for traders and high-tech investors. And it isn't as popular as the S&P 500 index, so fewer arbitrageurs try to front-run companies soon to be added or deleted from the S&P.
In our view, equal-weighting is most useful in allocation of industries.