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The recent performance of RSP (the Guggenheim S&P 500 Equal Weight ETF) has rekindled interest in equal weight ETFs. In RSP, each of the 500 stocks represents 0.2% of the portfolio. Contrast this with the SPY (SPDR S&P 500 ETF), which weights the portfolio by market cap. Market cap is defined as the total value of all the shares of a company. In the SPY, the larger the company, the higher the percentage representation in the portfolio. For example, in the SPY, Exxon Mobil XOM constitutes 2.78% of the portfolio (over 10 times the weight in RSP). Another large cap, Apple AAPL, currently comprises 2.76% of the SPY.

When the large cap stocks are in a bull market relative to medium or small caps, you would expect SPY to outperform the RSP. However, if one of the large cap constituents of the S&P 500 falls on hard times, such as what has happened to Apple recently, then you would expect RSP to outperform.

The RSP and SPY are highly correlated with one another (correlation over 90%) so you don't receive much diversification by having both in your portfolio. So the question is, over the long run, which is the better selection in terms of risk and reward? This is the question that I will attempt to answer in this article.

There are a relatively large number of equal weight ETFs, both for broad based indexes and specialized sector indexes. However, most of the equal weight funds are not very liquid, with trading volumes less than 50K per day. I will limit my analysis to the two most liquid offerings, RSP and QQEW. QQEW is the First Trust NASDAQ-100 Equal Weight ETF and will be compared to QQQ, the Powershares ETF tracking the NASDAQ-100.

First, I analyzed these ETFs over a complete market cycle, covering the bear market that began on 9 October, 2007 to the present day bull market. In Figure 1, I plotted the annualized rate of return in excess of the risk free rate (called Excess Mu on the charts) versus the volatility of these ETFs. The Smartfolio 3 program (smartfolio.com) was used to generate this chart. Over the last 5.5 years, RSP has had a better return than the SPY, but at the cost of a slightly higher volatility. For the NASDAQ-100, the cap weighted index, QQQ, has clearly outperformed the equal weight, with QQQ having both a higher return and less volatility.

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Figure 1: Equal-Weight versus Cap-Weighted over 5.5 Years

The Sharpe Ratio is a metric, developed by Nobel laureate William Sharpe, that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility (the reward-to-risk ratio if you measure "risk" by the volatility). It is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. RSP has a better Sharpe Ratio than SPY (.26 versus .18). Thus, over a complete cycle, RSP has performed better than its cap weighted brother. The opposite is true for the technology heavy NASAQ-100. The large cap technology stocks have had an excellent run, and have easily beat the equal weight index.

To gain more insight, I decided to shorten my look-back period to the last three years, when the market has been in a strong bull market. The 3 year data is shown in Figure 2. The absolute values of risk and reward are different, but relative to one another, the conclusions are the same. RSP has a better return than SPY, but also has a higher volatility. The QQQ again handily beats the equal weight counterpart.

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Figure 2: Equal-Weight versus Cap-Weighted over 3 Years

A number of articles have indicated that the equal weight S&P index should be compared to either a mid-cap or small cap index. Thus, I did one additional analysis and compared the risk-rewards of RSP against IJR IJR (the iShares Core S&P Mid-Cap ETF) and IWM IWM (the iShares Russell 2000 ETF for small cap exposure). Over a look back period of 3 years, RSP was highly correlated (greater than 96%) with both the mid-cap and small-cap indexes. The results of the risk-reward analysis are shown in Figure 3. RSP had roughly the same risk adjusted return as the mid-caps but was better than the small- caps.

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Figure 3: Comparison with Mid and Small Caps (3 years)

The bottom line is that there was no clear winner in the battle between equal-weight and cap-weighted funds. The "best" selection depended on which index was being studied and your portfolio objectives.

Source: Equal-Weight Versus Cap-Weighted ETFs