The Ins And Outs Of An Equal-Weighted ETF

Includes: RSP, SPY
by: Tom Lydon

Exchange traded funds typically track an index that is weighted by market capitalization, but some funds are led by an alternative method. The goal of an equal-weight strategy is to limit the amount of exposure a larger, more popular stock can contribute in an effort to limit over-allocation within a portfolio.

"The market has a nasty tendency of over-relying on the good companies and paying too large a premium (for them) on the tacit assumption that recent success portends long-term future success," Rob Arnott, CEO of investment firm Research Affiliates LLC, said in a recent MarketWatch report. The firm's RAFI indexes are tracked by several exchange-traded funds from provider Invesco PowerShares that rate stocks based on financial strength and other fundamental corporate measures.

Fans of the equal-weight indexing approach appreciate it for the idea that a smaller, up-and-coming company can have just as much allocation within an ETF as a large-cap, blue chip stock. In turn, this modifies the losses that can occur when a single stock takes a hit, reports Jonathon Burton for MarketWatch.

The run-up in Guggenheim S&P 500 Equal Weight (NYSEARCA:RSP) has supported the merit of an equal-weight strategy. RSP outperformed the SPDR S&P 500 (NYSEARCA:SPY) by an entire percentage point over the past 3 years, and by two points over the past 5 years, reports Burton.

Investors should not be too quick to switch to an equal-weight strategy without considering the risks. Equal-weight strategies can cause over-allocation or under-allocation to certain areas of the market, since the portfolios re-balance on a quarterly schedule. The value approach tends to sell winning stocks and buy lagging stocks, which is attractive for bargain hunters. The constant re-balancing, however, means that the ETF must be monitored regularly to avoid over-exposure to a particular company.

Also, since equal weighting in an index tends to favor small- and mid-cap stocks which can be more volatile than established large-caps, the amount of uncertainty can be heightened should the market take a downturn.

"You may be reducing your exposure to giant megacaps, especially when they reach bubble territory, but you're also dramatically increasing your exposure to small and midcap stocks, which tend to be more volatile," says Samuel Lee, an ETF analyst at investment researcher Morningstar Inc. "There's no free lunch."

One last point of caution: the ETFs that use an equal-weight strategy tend to be more expensive than a traditional market-cap weighted fund.

Guggenheim S&P 500 Equal Weight

Tisha Guerrero contributed to this article.

Full disclosure: Tom Lydon's clients own RSP and SPY.

Disclosure: I am long RSP, SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.