With the advent of new investment products each day, the retail investor now has many choices when looking to invest in an index fund. The most common way to track an index is in the form of a mutual fund or an exchange traded fund. In recent years, there have been an increasing number of both types of offerings in the marketplace.
Most index funds are market capitalization weighted. This means that the percentage of each security is based on each company’s market cap. There are also equal weight index funds which allocate an equal percentage of the overall portfolio to each company in the underlying index. Other formulas for indexing include price, dividend, and revenue weighting. There have been numerous studies which illustrate benefits of the various indexing methodologies.
Arguments can be made about which strategy is most effective, but this article will focus on the performance of equal weighted index funds in comparison to traditional market cap weighted funds. First we will take a look at the market cap weighted SPDR S&P 500 ETF (SPY) and the equal weight Rydex S&P Equal Weight (RSP). Over the past year, RSP is up 56.8% and SPY is up 39.3% (as of 4/9/10), a difference of 17.5%. Year to date, RSP and SPY are up 10.5% and 7.3% respectively, a difference of 3.2%. As small and mid-sized companies continue to outperform the large caps, more equal weight index opportunities will continue to present themselves.
RSP vs SPY Chart (1 Year):
Market Cap vs Equal Weight (Large Cap) Indices:
Small, Mid, and Large Cap Indices:
The latter figures make a comparison between large cap (SPY), mid cap (IJH), and small cap stocks (IWM). As you can see, there is a level of outperformance in the small and middle sized companies, especially over the past 3 months.
We see the same results in equal weight indices tracking areas such as financials, healthcare, consumer discretionary, materials, technology, utilities, and energy (RYF, RYH, RCD, RYM, RYU, RYT, and RYE). Every single one of these equal weight ETFs outperformed their market cap weighted counterparts by varying degrees. A quick glance reveals industrials is one of the only equal weight alternatives to underperform the normal market cap index.
Among other factors, investors should consider economic trends, trading volume, and expenses when determining suitability for their portfolios. Although many equal weight ETFs trade at very low volumes, they are still a viable option for many retail investors seeking the benefits of index funds with the added performance of equal weighting.
Over the past year, the case for equal weight indexing is hard to ignore. As long as small and mid cap indices exhibit higher growth than the large cap index, these equal weight funds will continue to show higher returns. Since these trends can last from 5 – 10 years, this method of indexing may be considered for core long-term equity positions.
Author's Disclosure: Long RSP
Source: A Case for Equal Weight Indexing