Equal Vs. Cap Weighted ETFs: Dividend And Risk Consequences

| About: SPDR S&P (SPY)

In this article I wish to highlight some of the differences (and surprising similarities) between Capitalization weighted ETFs and Equal weighted ETFs. I will compare the SPDR S&P 500 Trust (NYSEARCA:SPY) with its equal weighted cousin, Guggenheim S&P 500 Equal weight ETF, (NYSEARCA:RSP).

First: definitions and clarifications. A Capitalization weighted index or portfolio means companies that have a larger market capitalization (defined as price times number of shares outstanding) carry more "weight" in the index that smaller firms. If you look at SPY for example, you will find that Apple Inc (NASDAQ:AAPL) and Exxon (NYSE:XOM) total nearly 5% of the weight of the index.

In contrast, an Equal weighted index, all the companies have equal weight, regardless of their size. With RSP, AAPL and XOM combined carry merely 0.37% of the weight. Stated subjectively, a big up day for these two behemoths would have a noticeable impact on SPY but a negligible impact on RSP.

Another way of contrasting the two? With an Equal weight portfolio you invest an equal dollar amount in each company; with a Cap weight portfolio you invest more in the "big" companies and less in the smaller ones. I'll show an example of this later in the article.

So what are some of the differences between the two? You might be surprised.

  • First, since the Capitalization portfolio has a good chunk of its total funds in a smaller subset of stocks, you might expect it to be more risky than the very spread out Equal weighted portfolio. In fact, it is the exact opposite: RSP has a beta of 1.16 according to Yahoo finance, while SPY (basically by definition) has 1.00 as its beta.

Odd? Think about it: the former has more money in smaller firms, which tend to be riskier than large cap blue chips. Remember this when you read reports that suggest equal weighted portfolios perform better than their Cap cousins. You are not getting a free ride. They are more risky.

  • Second, Cap weighted portfolios and ETFs chase after advancing stocks; Equal weighted ETFs trim their positions in them.

This is best illustrated with a lengthy example. Imagine two portfolios which hold only five stocks, A,B,C,D, and E, all of which sell for $20 a share at the start. They also have the same number of shares outstanding. You have $1000 to invest. At the start, both the equal and cap weighted portfolios look identical.

The Equal weight portfolio buys 10 shares of each stock; $200 for each of the five, totaling $1000.

The Cap weight portfolio places an equal amount of money in each company; since they all have the same market cap, $200 each for the five, also totaling $1000.

Now suppose company "A" triples to $60, and company "E" drops sharply to $5. Compare the two portfolios below.

Stock Equal Weighted Amount Market Weighted Amount
A $600: ten shares @ 60 $600: ten shares @ 60
B $200 $200
C $200 $200
D $200 $200
E $50: ten shares @ 5 $50: ten shares @ 5

While both portfolios have pleasantly advanced 25% in value to $1250 each, the managers face different decisions in the future.

The Equal weighted fellow now sees that his "weights" are out of kilter. He now has almost half of his holdings in company "A" and a smidgen in "E". To be equal weighted he must rebalance, and place (1250/5)= $250 in each stock. Thus going forward---and investing is about future performance, not the past, right?---you must sell $350 of your best performer and re-allocate it to the other four stocks. Note that $200 of that $350 would pour into company "E".

Would you want to do that? Perhaps, but many investors would be more interested first in seeing why company "A" soared, and why "E" was the dog. Fine and dandy, however, then you are no longer a equal weighted index/portfolio fan. And thus an ETF like RSP is not your cup of tea.

What if more money was coming in? This happens all the time to ETFs and mutual funds: after all they are trying to grow and manage more assets. You have to direct those funds disproportionately to your underperformers, and away from your stars.

By the way: not that this strategy is, in and of itself, a bad one. Trimming gainers and seeking out bargains doesn't sound half bad. But Equal weighting is not exactly the same thing: there is no analysis of earnings or cash flow or other valuation methods. Instead, more money flows into falling stocks. Period. This strategy is forced upon managers of Equal weighted ETFs whether they want it or not.

What about the Cap weighted portfolio? At the moment the manager is happy with how "A" has performed. But when new money comes in, as it surely will, the manager is forced to allocate almost half (48%, for you math buffs) of his funds to company "A" since that is the weight of company "A" in his portfolio and the index which he tracks. So a market weighted portfolio chases performance, and ETFs which follow this strategy will put more and more money into advancing stocks. Since most portfolios on Wall Street are cap weighted, should we wonder where bubbles come from?

  • Third, the risk profiles of the two strategies will differ, but not by as much as you think. Over time Cap weighted portfolios will be dominated by large companies, which tend to have betas closer to 1.00 than their smaller brethren.

Small firms tend to have higher betas, so as we suggested at the top, the Equal weighted portfolio would tend to be more risky.

  • Fourth, What about dividends? That can be tricky. The equal weighted portfolio tends to emphasize smaller companies, which pay smaller dividends.

Furthermore companies falling in price are unlikely to raise, and more likely to cut, their payout. Since these companies attract more cash as time progresses, we would expect the Equal weighted portfolio to have a lower, and more slowly growing, dividend. This appears to be the case: the equal weighted ETF, RSP has a yield of 1.31%, while cap weighted SPY boasts 1.88%, according to Yahoo Finance. Thus you should not make equal weighted ETFs part of a dividend growth strategy.

Disclosure: I am long XLV, IHI, XLK. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.