Seeking Alpha
Profile| Send Message|
( followers)  

Advisors and individuals who favor a tactical asset allocation to investing have historically analyzed broad macroeconomic trends and statistics to identify asset classes and sectors poised deliver strong returns. In the early days of the ETF industry, this meant homing in on a certain sector or style and picking the fund that tracked that segment.

But as the landscape has continued to evolve, asset class and investment style aren’t the only decisions investors face. Market capitalization weightings were once the only game in town, but in recent years alternative weighting methodologies have become more popular among investors who find flaws in a strategy that gives the most weight to the biggest companies.

The vast majority of ETF assets is still in traditional market capitalization-weighted funds (and most of the largest and most popular ETFs fall into this category). But investors have embraced a number of other strategies in recent years, including:

  • Equal Weighting: Instead of tying a company’s weighting in index to the market capitalization of the company, equal-weighted benchmarks give each component an identical allocation. As certain stocks outperform these others, weightings will gradually shift, making occasional rebalancing necessary.
  • Earnings Weighting: A number of indexes now rely on the relative earnings of a company to determine the appropriate allocation, giving the highest weightings to companies with the highest earnings over the previous four quarters. This strategy avoids companies with zero or negative earnings, which potentially establishes a bias towards value stocks (since growth companies are more likely to be losing money).
  • Dividend Weighting: Similar to earnings weighting methodologies, this strategy gives the biggest weights to the companies that have paid the most dividends. Because dividends can’t be manipulated like earnings (or to a lesser extent, revenue), indexes that base allocations on this fundamental metric should limit exposure to firms that are “cooking the books.”
  • Revenue Weighting: Instead of focusing on “bottom line” metrics such as earnings and dividends, there are now a handful of benchmarks that determine allocations to individual companies based on top-line revenue. This methodology in effects overweights companies with low price-to-revenue ratios and underweights companies with high ratios.

Several ETF issuers have begun specializing in certain of these “alternative” methodologies:

Alternative Weighted ETF Providers
Equal Weighted Rydex
Earnings-Weighted WisdomTree
Dividend-Weighted WisdomTree
Revenue-Weighted RevenueShares

Numbers Don’t Lie

Each of these weighting strategies is based on a sound investment thesis and supported by a great deal of research and analysis. But hypotheticals don’t do a whole lot for investors looking for the best way to play a certain asset class, so we took a look at the returns generated by ETFs that maintain similar individual holdings but are differentiated primarily by the weighting methodology employed

Some of the results were quite shocking. Most of these ETFs hold a very similar group of companies, with the major difference being the allocation given to each. It seems like a small detail, but the impact on performance can be major.

Large Cap Equities

The first group we considered was large cap equities. We compared the well-known SPY to several funds that also hold the largest U.S.-listed companies by market capitalization. The holdings of these ETFs aren’t identical. EPS is based on an index that includes the 500 largest companies with positive earnings over the last year, while DLN invests in the 300 biggest dividend-paying companies. But all of these funds invest in large cap equities, meaning that any differences in performance are attributable mainly to the weighting methodology employed by the underlying indexes.

Ticker ETF Methodology YTD Return
SPY S&P 500 SPDR Market Cap 18.5%
EPS WisdomTree Earnings 500 Fund Earnings 19.8%
DLN WisdomTree LargeCap Dividend Fund Dividends 9.1%
RWL RevenueShares Large Cap Fund Revenue 22.8%
RSP Rydex S&P Equal Weight ETF Equal 34.8%
All returns as of 10/26/2009

The winner: Equal weighting, in a landslide, although revenue-weighting and earnings-weighting strategies have also outperformed traditional cap-weighting this year.

Mid Cap Equities

Investors looking to gain exposure to mid cap equities also have a number of options. Rydex doesn’t offer an equal-weighted mid cap equities ETF, so this analysis included only four weighting methodologies. Again, the holdings of these ETFs aren’t necessarily identical, but the focus of mid cap equities means that there is significant overlap.

Ticker ETF Methodology YTD Return
IJH iShares S&P MidCap 400 Index Fund Market Cap 30.1%
EZM WisdomTree MidCap Earnings Fund Earnings 40.5%
DON WisdomTree MidCap Dividend Fund Dividends 19.7%
RWK RevenueShares Mid Cap Fund Revenue 43.0%
All returns as of 10/26/2009

The winner: Revenue weighting and earnings weighting strategies have both outperformed market cap ETFs by a fairly wide margin this year.

Small Cap Equities

The differences in return in the large cap and mid cap groups were significant, but nothing compared to the variances in small cap ETFs.

Ticker ETF Methodology YTD Return
IJR iShares S&P SmallCap 600 Index Fund Market Cap 18.4%
EES WisdomTree MidCap Earnings Fund Earnings 42.3%
DES WisdomTree MidCap Dividend Fund Dividends 12.9%
RWJ RevenueShares Mid Cap Fund Revenue 42.1%
All returns as of 10/26/2009

The winners: Again, revenue-weighted and earnings-weighted ETFs have crushed similar funds that use dividends and market capitalization to determine allocations to individual holdings.

The Verdict (And A Word of Caution)

In 2009, market capitalization-weighted ETFs have lagged many of their peers that rely on similar but unique benchmarks. ETFs that are based on earnings-weighted and revenue-weighted benchmarks have been the best performers, beating indexes focusing on dividends and market capitalization by a wide margin.

The stocks selected to make up an index will clearly have an impact on the returns delivered. But it is also clear that the manner in which the weightings to those stocks is calculated drives performance as well. Revenue-weighting and earnings-weighting methodologies have delivered excess returns this year, while cap-weighting and dividend-weighting strategies have struggled. But this performance is over a relatively short time period, and it certainly isn’t sufficient to conclude that a single methodology will be superior in all economic environments.

Still, these strategies are certainly worth a look, as some may consistently outperform in certain economic environments. For more information on these weighting methodologies, see these valuable resources (note that some materials are for financial advisors only). For more looks “under the hood” of ETF strategies, be sure to sign up for our free ETF newsletter.

Disclosure: No positions at time of writing.

Source: Evaluating Weighting Methodologies: An ETF Report Card