Equal Weight Index Funds and the Sin of Portfolio Management

| About: Guggenheim S&P (RSP)
Josh Brown pointed his readers toward an intelligent WSJ article about the trend toward equal weighted index funds. As a refresher - indices like the S&P 500 are market cap weighted - indexers own shares in proportion to the market caps of the companies. This obviously results in index performance that is dominated by the performance of the larger companies, which have larger component weights.
As a "remedy" to this phenomenon, index providers are starting to roll out "equal weight" versions of these same indices. In the NDX - Nasdaq 100 - for example, which is a modified cap-weighted index, the top handful of components dominate the index (rough weights as of today):
Apple (NASDAQ:AAPL): 20%
Google (NASDAQ:GOOG): 4.7%
Microsoft (NASDAQ:MSFT): 4.1%
Oracle (NASDAQ:ORCL): 3.1%
Amazon (NASDAQ:AMZN): 2.5% Cisco (NASDAQ:CSCO): 2.4%
Intel (NASDAQ:INTC): 2%
Teva Pharmaceutical (NYSE:TEVA): 2%

Research in Motion (RIMM) 2%

That's roughly 47% of the index made up of only the top 10 names.

In an equal weighted Nasdaq-100 basket, however, each component would get a 1% weight, and the smaller companies have a significantly higher impact than they do in the modified cap weighted (ie, "regular") NDX. The top 10 names would make up 10% of the index (after a rebalancing).
The thing that strikes me as most unsavory about the equal weighted indices, though, is their rebalancing schedule. The funds generally rebalance quarterly to get back to the equal weightings - selling the stocks that have appreciated, and buying more of the stocks that have depreciated. To me, that reeks of one of the cardinal portfolio management mistakes that every new trader learns at some point - hopefully as quickly as possible: you don't want to sell your winners and let your losers run, and you don't want to sell your winners and increase positions in your losers.
That's not to say that equal weight indices will perform worse than their market cap weighted counterparts - I'll get to that in a minute - but rather, that I'd prefer it if the equal weight funds rebalanced less frequently. If the rebalancings occurred annually, or even bi-annually, it would give the winners a chance to run a little bit, while at the same time making sure that the weights don't get so out of whack that a few big boys dominate the index. In other words, I think that an improvement to equal weight funds could be "slow rebalance equal weight funds" that don't constantly trim their winners and re-load on their losers.
So how do the equal weights perform vs. the cap weights? It shouldn't be hard to deduce that when smaller cap stocks are outperforming, the equal weight indices will do better - since they give larger relative weightings to the smaller capitalization companies. Similarly, when large caps are outperforming, the market cap weighted ("regular") indices should do better.
We'll keep an eye on the equal-weight fund sector and watch how their assets grow. As the WSJ notes, the $40B in ETFs tracking alternative indices is a small fraction of the $1.8 Trillion in traditional index products.