The equal-weighted indexing strategy is a simple alternative to market-cap weighted indices and can be a good way to gain a tactical position within a portfolio. The equal-weighted strategy can be used in exchange traded funds and gives each stock the same weighting within the portfolio.
"Exchange-traded funds are often used to make short-term, tactical bets on certain sectors. In this case, you want exposure to an entire industry, not just to a handful of mega-cap stocks. Equal-weighted sector funds, such as Guggenheim S&P 500 Equal Weight Energy (NYSEARCA:RYE), may make more sense when seeking industry exposure," Michael Rawson wrote in a recent Morningstar article.
The equal weighting strategy gives both small and large caps an equal weighting within an index fund or portfolio. This allows all of the companies to be considered on an even playing field. Equal-weighted index funds tend to have higher stock turnover than market-cap-weighted index funds and, as a result, they usually have higher trading costs, according to Investopedia.
An equal-weighted methodology is considered an alternative form of indexing, with the basic market-cap-weighted index being the most common. There are risks associated with equal weighting, such as the potential for concentration in a handful of stocks within sector funds. Additionally, equal-weighted ETFs are intended for use as a tactical holding, rather than used as a core holding within a portfolio.
Rawson also reports that there are three potential sources of extra return from an equal-weight index. There is a small size tilt from under-weighting mega-cap stocks and over-weighting smaller stocks. Also, there is a value angle from under-weighting overpriced glamor stocks. The third potential source of return is from contrarian rebalancing. In order to maintain equal weightings, the index must sell stocks that have recently appreciated and buy stocks that have recently declined.
Overall, an equal-weight index is known to perform better when the market favors small or mid-cap stocks. An equal-weight index also avoids excessive valuations, when the market is driven by momentum.
Here's a list of equal-weight ETFs:
- Guggenheim S&P Equal Weight ETF (NYSEARCA:RSP)
- Guggenheim S&P EQual Weight Technology (NYSEARCA:RYT)
- First Trust NASDAQ 100 Equal Weight Index Fund (NASDAQ:QQEW)
Disclosure: I am long RSP. Tom Lydon's clients own RSP.
Disclaimer: Read the disclaimer here; Tom Lydon is a board member of the funds for Guggenheim Investments.