All indexes may be created equal, but they're not all created equal-weight and that's a fact ETF investors should note and embrace when thinking about equal-weight ETFs.
For those not familiar with equal-weight ETFs, the first was the Rydex S&P 500 Equal-Weight ETF (NYSEARCA:RSP), which was created in 2003 to track the S&P 500 Equal Weight Index. (Rydex is sort of the king of equal-weight ETF issuers.)
You may be thinking: What's the big deal? Just another ETF tracking the S&P 500, who cares? Not so fast. There are big differences between equal-weight indexes and traditional cap-weighted indexes, such as the S&P 500. As a quick refresher, the S&P 500 is weighted by its constituents market value, meaning Exxon Mobil (NYSE:XOM) gets the heaviest weight in the index, Apple (NASDAQ:AAPL) the next heaviest and on down the line.
On the other hand, equal-weight indexes and ETFs do exactly what their name implies: Each index member gets the same weight as the others. Using RSP as an example, Exxon and Apple get the same weights as the stocks with the two smallest market values in the S&P 500. Alright, so now the $64,000 dollar question is do equal-weight ETFs have the potential to outperform their cap-weighted counterparts? Indeed they do.
In October, ConvergEx released data that showed that RSP had returned twice as much as the SPDR S&P 500 ETF (NYSEARCA:SPY) this year with just 20% more risk. Put another way, for every dollar put on the line with SPY, an investor would have only needed to risk 20 cents more to double up his returns with RSP.
As the chart illustrates, it is entirely possible to assemble two groups of the same stocks and garner vastly different results just by tweaking the weights those stocks receive.
To be sure, equal-weighting isn't perfect. For example, equal-weight indexes can be more volatile than their cap-weighted peers. As highlighted by Investopedia, for the five years ending December 2007, the annualized standard deviation for the S&P 500 Equal-Weight Index was 10.97% compared to 8.61% for the traditional index.
On the other hand, there are several distinct advantages to being involved with equal-weight ETFs, including the following:
Since their risk-adjusted performance over the long haul is more consistent than cap-weighted funds, equal-weight ETFs can be embraced by longer-term investors.
By nature, equal-weight funds are more diverse because all constituents receive the same allocation.
Equal-weight ETFs rebalance once per quarter to enhance risk control by reducing concentration risk, according to ETFTrends.
Now don't go dumping all of your cap-weighted index funds in the essence of going equal-weight crazy, but do consider taking a look at an equal-weight ETF or two. The data shows the risk is worth the reward.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.