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By Patrick Watson

Yet another permutation of the stock market began trading in ETF form today. ALPS Equal Weight Sector ETF (EQL) will try to gain an edge by breaking down large cap U.S. stocks by sector and then equally weighting them. It is a strategy that would have worked well in the past. Will it succeed in the future?

EQL is actually a fund of funds – an ETF that is composed of other ETFs. The underlying portfolios are the nine Select Sector SPDR funds, which allow investors to break down the S&P 500 by sector. The Technology Select Sector SPDR (XLK), for instance, includes all the technology companies that are members of the S&P 500. These were some of the first ETFs created and remain very popular today. All have substantial assets and trading volume. ALPS is the Denver-based company that distributes them.

Because the individual stocks that compose the S&P 500 fluctuate in value, the proportion that each sector represents within the index also varies over time. For a long time the “Big Three” sectors were Financials, Technology and Health Care. The breakdown changed considerably in the last two years with the huge rally in Energy and the downfall of banks. Currently, the three largest sectors, as measured by market capitalization, are Technology, Financials and Energy. Together they account for about half of the S&P 500, so their weightings in EQL will be much less. Materials and Utilities are the smallest sectors in the S&P 500 and will therefore enjoy higher weightings in EQL.

EQL will follow what seems like a simple plan: buy all nine Select Sector SPDR ETFs with an equal weighting, roughly 11.1% each, then rebalance quarterly. The result is that growing sectors will be trimmed back as they increase in value, while lagging sectors will receive additional investments. In a sense it is similar to ”asset allocation rebalancing” techniques followed by many long-term investors.

A study conducted by ALPS found that following this strategy over the last ten years would have added 306 basis points (3.06%) to a buy-and-hold investment in the S&P 500 while actually reducing volatility. For this particular time period, outperforming by 306 basis points a year simply means you broke even instead of losing ground, but the improvement is still significant.

One problem with the EQL structure is that there are two layers of fees: 37 basis points for EQL and 18 basis points for the component ETFs. Conceivably, one could buy the nine Select Sector SPDRs at the appropriate proportions and rebalance every quarter, thereby saving 37 basis points each year. Doing this would be a lot of work, though, so most investors who wish to implement this kind of portfolio are probably better off buying EQL.

As with all such strategies, EQL will likely be effective only to the extent it has time to work; it is not a trading vehicle. Long-term stock investors should take a look at EQL.

EQL Fact Sheet (pdf)

Prospectus (pdf)

Source: ALPS' New Equal Weight Sector ETF Backtested Well: Will Its Outperformance Continue?