Alternative Indexing: Considering Equal Weight ETFs

by: Tom Lydon

Most Index exchange traded funds (ETFs) hold specific weightings of underlying securities based on market capitalization. Market cap weighting has been the cornerstone of index construction – look at the Dow Jones Industrials and the S&P 500 Index. Today investors are warming up to other forms of index construction, like equal-weight indexing the the ETFs that represent them.

The equal-weighting schematic is transparent, inexpensive and helps diversify, writes Will McClatchy for ETFZone.

In equal-weighted funds, every company within the fund is owned in equal amounts. For instance, the Rydex S&P Equal Weight ETF (NYSEARCA:RSP) holds each S&P 500 company in equal quantity, whereas the actual S&P holds the top 10 firms at around 20% of assets and the bottom 10 at less than 1%. Additionally, in a five-year comparison with the S&P, RSP dropped and recovered faster than the underlying index.

By placing each company in equal weight, the fund spreads out the individual risk of an ailing company from heavily affecting the ETF. If 500 stocks were held in equal ratios, the risk of one company tanking is about .2%, as compared to the 1% to 5% exposure for each of the top 10 holdings of the S&P.

Since equal-weight ETFs hold small- and mid-caps in equal with with large-caps, equal-weight ETFs may slightly outperform market-cap ETFs – smaller companies outperform larger ones in the long run.

If you like to pick out individual sectors to tailor your investments needs for the day, then you may consider equal-weight sector ETFs, as well:

  • Rydex S&P Equal Weight Consumer Discretionary ETF (AMEX: RCD)
  • Rydex S&P Equal Weight Consumer Staples ETF (AMEX: RHS)
  • Rydex S&P Equal Weight Energy ETF (AMEX: RYE)
  • Rydex S&P Equal Weight Financial ETF (AMEX: RYF)
  • Rydex S&P Equal Weight Health Care ETF (AMEX: RYH)
  • Rydex S&P Equal Weight Industrials ETF (AMEX: RGI)
  • Rydex S&P Equal Weight Materials ETF (AMEX: RTM)
  • Rydex S&P Equal Weight Technology ETF (AMEX: RYT)
  • Rydex S&P Equal Weight Utilities ETF (AMEX: RYU)

Rydex equal-weight company holdings usually don’t exceed 5%.

It should be noted that liquidity for these funds can drop and the strategy emphasizes fragmented industries. For example, as financials recently rose in prominence, volatility also spiked. Additionally, one shouldn’t replace small-cap holdings for equal-weighting plays.

Another equal-weight play is the First Trust NASDAQ-100 Equal Weighted ETF (NASDAQ:QQEW), which holds large-cap high-tech stocks that have good liquidity.

Read the disclaimer; Tom Lydon is a board member of Rydex|SGI.

Max Chen contributed to this article.

Disclosure: None