What Are They?
- Most ETFs are market-cap weighted, meaning that larger companies have greater representation in the index, and if a stock's price rises fast, its weighting in the index rises. In contrast, these ETFs are equal weighted, meaning that all stocks have similar initial weightings in the index tracked by the ETF, irrespective of the companies' size, earnings or revenues.
- EQL provides equal weighting between entire sectors, rather than individual stocks.
Why & How To Use Them
- Equal weight ETFs will outperform market cap weighted ETFs when the smaller stocks in an index outperform the larger stocks in an index. Equal weighted ETFs also avoid overweighting stock which become overvalued.
- To maintain roughly equal weighting, the stocks held by an equal weight ETF need periodic rebalancing. If the underlying stocks fluctuate signficantly, that rebalancing can lead to outperformance compared to a market cap weighted ETF, which doesn't require rebalancing as a higher constituent stock price automatically leads to a higher weighting in the underlying index.
- Equal weighting of stocks in an index is better suited to industries that don't display increasing returns to scale. Equal weighted ETFs may therefore be better suited to basic materials than to technology, for example.
- The argument for using international and US sector ETFs as the basic building blocks of a portfolio is that doing so makes your portfolio more granular, providing more rebalancing opportunities.
What to Look Out For
- Compared to more traditional index ETFs, sector ETFs and equal weighted ETFs tend to have higher expense ratios and wider buy-sell spreads (which makes them more costly to purchase and sell).
- The rebalancing required for equal weight ETFs also leads to higher transaction fees and lower tax efficiency, since the stocks that have appreciated most are the ones that need to be sold.
- Articles about equal weighted ETFs: Equal Weight ETFs Offer a 'Compelling and Rich' Alternative to Standard Cap Weighting (Gary Gordon), Should You Use an Equal-Weight S&P 500 Fund Instead of a Market-Cap Weighted Fund (RSP versus SPY or IVV)? (David Jackson), SPY vs. RSP: Market Cap Versus Equal Weight ETFs (Herb Morgan), Rydex's New Equal Weight Sector ETFs (Roger Nusbaum).
- The primary benefit of using sector ETFs as the basic building blocks of a long-term portfolio is the rebalancing opportunity they provide. For more on rebalancing, see Rebalancing Rules.
- Equal weighted ETFs may be ill-suited to technology stocks due to the "winner takes all" nature of many tech markets. For discussion, see The Problem With Tech Stocks.
This page is part of The Seeking Alpha ETF Selector which sorts ETFs by type, highlights how to use them and what to look out for, and provides links to articles that discuss key issues for investors.