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By Michael Rawson, CFA

Over the past 10 years, Guggenheim S&P 500 Equal Weight (RSP) has crushed the S&P 500, returning 9.48% per year compared with 7.23%. However, a quick glance at the Morningstar Style Box should alert investors that this is a poor comparison. The RSP portfolio behaves more like a mid-cap portfolio than the large-cap S&P 500. By that score, RSP has underperformed the S&P MidCap 400 by more than a percent per year. While fund marketers might like to advertise equal-weighting as providing a smarter beta or better diversification, the truth is that it is closer to a bait-and-switch. While the exposure is clearly mid-cap, equal-weighting does generate legitimate alpha from the forced buy low-sell high rebalance strategy. Investors would keep more of this alpha if it weren't for the fund's relatively high expense ratio of 0.40%.

A Better Beta
Of all of the non-market-cap-weighted investment strategies, the simplest to conceptualize is equal-weighting. Here, each stock has the same weighting in the portfolio. In the equal-weighted version of the S&P 500 Index, giant caps like Apple (AAPL) carry the same heft as mid-caps like AutoNation (AN), despite the fact that Apple has a market cap more than 200 times larger. Thus, the fund is a better supplement for mid-cap exposure and is best used as a satellite or tactical position rather than a core holding.

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Source: Morningstar.

Market-cap-weighted indexes skew toward the largest companies in the index, leading to a concentration in giant-cap names. A full 20% of the S&P 500 is held in just 10 stocks. That concentration gets muted in an equal-weighted fund such as RSP, so that just about 2% of the equal-weighted S&P 500 resides in the top 10 stocks. In essence, the equal-weighted index takes large underweightings in a handful of mega-cap stocks and takes small overweightings in many large- and mid-cap stocks. While some might argue that this lowers concentration risk, those mega-cap names tend to have very low volatility compared with mid-caps.

One way to measure the extent of exposure to smaller-cap stocks is to run a regression model. Regression is a statistical method used to break down returns by source or to analyze risk exposures of a fund. Since 2003, the equal-weighted version of the S&P 500 has had a beta to the traditional Fama-French SMB (small minus big) factor of positive 0.19 while the S&P 500 has a beta of negative 0.15, indicating that it tilts in the opposite direction toward mega-caps.

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Still, that regression also reveals that equal-weighting generated an excess return, or alpha, of about 0.11 basis points a month. A paper by Yuliya Plyakha, Raman Uppal, and Grigory Vilkov demonstrates that the source of the alpha in an equal-weighted strategy is the rebalance. But this is for the index. In the real world, RSP has to overcome the expense ratio and trading costs. As a result, RSP investors could only capture an alpha of 0.07% per month or about 0.84% per year.

Is Now the Right Time to Increase Mid-Cap Exposure?
Despite the recent uncertainty, the stock market is near all-time highs. The S&P 500 trades at a price/trailing earnings of about 18.3 times, which is rich compared with historical multiples. Our equity analysts, who assign price/fair value estimates on 98% of the stocks in the index, see those stocks as trading at a price/fair value of 0.98. However, by equal-weighting and putting more emphasis on mid-cap stocks, the price/fair value becomes slightly more expensive at 1.01 times. In addition, these mid-caps are slightly lower quality, with only 19.6% of assets having a wide moat, compared with 43.0% for the S&P 500. The lower moat ratings are reflected in the greater volatility of RSP, 17.8% compared with 14.6% for the S&P 500. Investors in RSP should be prepared to greater volatility than they would have in the S&P 500.

Even after a sober look, we like the equal-weighted strategy. But at 0.40%, it is difficult to recommend RSP. This was one of the first strategy ETFs to launch, and its expense ratio does not reflect today's competitive landscape. The methodology is fairly simple and does not require a black-box model, but RSP has lagged its benchmark by more than its expense ratio, indicating high trading costs or poor execution.

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.

Source: In The Performance Race, This Fund Is On The Wrong Track