Equal Weight ETFs: Will Tilting Your Portfolio Help You Or Hurt You?

by: Gary Gordon

Over the years, I have written articles extolling the virtues of “Equal Weight” ETFs at the expense of traditional market-cap weighted index ETFs. The folks at Rydex (now Guggenheim) certainly appreciated my observations; several equal-weight advocates even asked for republishing rights.

Here are a few examples:

1. Equal Weight Edging Out Market Cap (June, 2007). In this feature, I described the differences between basic indexing and equal weighting. Whereas the largest companies in the S&P 500 have a greater influence in the outcome of the S&P 500 SPDR Trust (NYSEARCA:SPY), each of the constituents in Guggenheim (Rydex) S&P 500 Equal Weight (NYSEARCA:RSP) has the same impact on the asset’s performance. In the bull market period of the time, RSP produced better upside gains.

2. Equal Weight ETFs Offer A Compelling Alternative (December, 2010). In this editorial, I showed performance data for equal weight possibilities in energy, technology and materials. Indeed, investors who may eschew liquidity and volatility in favor of enhanced upside potential could usually garner more upside through equal weighting; one could choose funds like Guggenheim (Rydex) Equal Weight Technology (NYSEARCA:RYT) over SPDR Select Technology (NYSEARCA:XLK) and/or Guggenheim (Rydex) Equal Weight Materials (NYSEARCA:RTM) as opposed to SPDR Select Sector Materials (NYSEARCA:XLB).

Without doubt, a case can be made that equal weighting has passed the test of time as well. With the 2008-2009 financial collapse in the mix of the prior decade, Guggenheim S&P 500 Equal Weight (RSP) appears to be a runaway success story relative to the mainstream’s favorite, S&P 500 SPDR Trust (SPY).

Click to enlarge

On the other hand, what are we really comparing? Does RSP add “smarter beta” of the broader market’s large-cap space? Or does the equal weighting of RSP merely tap market-cap weighted performance of smaller corporations?

I decided that it made sense to see how different Guggenheim S&P 500 Equal Weight (RSP) acted when compared not to SPY, but rather, the market-cap weighted iShares Russell 2000 (NYSEARCA:IWM). Surely, if RSP represented a smarter way to capture larger company performance, there should be some noteworthy differences in price movement between RSP and a premier small cap tracker like IWM. Alas, the two are virtually indistinguishable over the last 10 years.

Click to enlarge

As much as I may genuinely believe in equal weighting, the price performance of IWM relative to RSP suggests that the latter seems to capture what a traditional market-cap weighted index for smaller companies might capture. What’s more, since one is often pursuing a course of diversification, would they not be getting more diversification through a combination of SPY/IWM as opposed to RSP/IWM?

There is one other possibility for equal-weight fans. Perhaps a combination of equal weighting the S&P 500 with RSP and equal weighting the Russell 2000 with Guggenheim Equal Weight Russell 2000 (EWRS) would produce the desired diversification, “smart beta,” and performance enhancement.

Still, EWRS does not seem to differentiate much from the market-cap weighted IWM. And, unfortunately, we do not have 10 years of data to discover whether a combination of RSP/EWRS would offer as much diversification and differentiation as we know SPY/IWM offers.

Click to enlarge

There’s plenty of research to suggest that equal weight investing is more beneficial than traditional market-cap weighted investing. On the other hand, back-tested research often overlooks enormously important features such as liquidity. With a mere $26 million in AUM, Guggenheim Equal Weight Russell 2000 (EWRS) would be less tradable at a desirable bid-ask spread in volatile periods. Moreover, with the price movement of Guggenheim S&P 500 Equal Weight (RSP) mimicking the price movement of iShares Russell 2000 (IWM), it is not clear if an across-the-board equal weight approach is really a ticket to success.

I still believe that equal weight has a place in portfolio construction and asset allocation. In fact, I think the greatest opportunity might rest in equal weighting sectors, since it may be more difficult tapping combinations of large technology companies and small technology companies; it may be wise to utilize an equal weight tech ETF and/or an equal weight energy ETF rather than attempting to combine large and small sector funds. At present, though, using traditional large and small in the broader market benchmarks provides the liquidity and strategic diversification that most investors require.

Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.