Recently, we sat down with Tony Davidow, the Managing Director-Portfolio Strategist at Rydex SGI, at our headquarters in Chicago. In Tony’s current role, he has helped to spread the word on "alternative" weighting methodologies beyond the traditional market-cap weighted system that most benchmarks use today. In this interview, we discuss why market cap weighting has been so popular up to this point and why equal weighting may make sense for some investors.
ETF Database (ETFdb): Why has market cap weighting historically been dominant as benchmarks for mutual funds, and more recently the underlying index for ETFs?
Tony Davidow (NYSE:TD): We have grown up in a world where we look at the cap weighted benchmarks as the de facto “market portfolio.” We would challenge that notion, and suggest that there are different ways of owning the market. There is a fair amount of academic literature challenging the norm (see some of the reports at the EDHEC for more info). One of the challenges that we are faced with is that very question - “how is the best way to own the market, and is there a better beta?”
ETFdb: It seems like it has become a more important question recently, especially with the ETF boom, indexes have essentially become investable assets. Do you think this has led to more scrutiny?
TD: Until recently, there weren’t a lot of alternative ways to own the market. Now there are several different types of fundamental ETFs, and of course equal weight ETFs. The decision has evolved beyond merely “active” vs. “passive" to include different methodologies of owning the market. For many years, active managers knew that if they wanted to outperform their benchmark, they needed to be different than the benchmark. With the growth of the ETF industry, and with these alternative weighting strategies, it affords the investor a lot more ways of owning the market segment. We would argue that is a very good thing for investors.
ETFdb: What is the value proposition behind equal weighting, and why might this methodology make sense as a basis for an indexing strategy or an ETF?
TD: First, allow me to explain how equal weighting works. As the name suggests, we own the same holdings as the cap weighted benchmark. But rather than weight based on capitalization (i.e., the largest companies represent the largest percentage of the portfolio), we own each name equally. To retain the integrity of the equal weighting, on a quarterly basis, we rebalance back to the equal weight. In other words, we trim those companies that have risen the most, and increase our positions in those companies that are underweighted.
There are a couple of key attributes that are common to our strategies. Our equal weight ETFs provide (1) strong risk-adjusted performance, (2) disciplined rebalancing, and (3) diversification. The S&P 500 cap-weighed is a concentrated portfolio, the top 10 companies represent 20% of the portfolio, and the top 50 represent 50% of the portfolio. Therefore, you are making a very large mega-cap bet. Equal weighting spreads the risk and the opportunity across all 500 names equally. Equal weight allows for a larger contribution of return coming from the small- and mid-cap names. It is not a small- or mid-cap portfolio, but the smaller names in the S&P have an equal opportunity to contribute to the returns.
Another key component to our equal weight ETFs is our rebalancing process. On a quarterly basis, we rebalance the portfolio, bringing the weights back to equal. By rebalancing, we are trimming names that have appreciated the most in the portfolio, and then we are buying the names that have not appreciated as much in the portfolio. The disciplined rebalancing process serves to “sell high” and “buy low."
ETFdb: Isn’t there also another part to that whereby value is added by breaking this link between stock price and security weight? Avoiding the tendency of cap weighted indexes to overweight overvalued stocks and vice versa?
TD: The classic line is that cap weighted means that you “overweight the overvalued” and “underweight the undervalued” companies. In 2007, Financials were performing well, and grew to be a larger component of the S&P 500. Obviously, we all remember what happened to financial stocks in 2008. Our equal weight discipline allowed us to trim positions rather than be exposed to overweighting.
ETFdb: A lot of people focus on individual weighting as far as individual securities go, but there are also some products that assign weights equally across sectors. What is the methodology behind that strategy?
TD: We believe in equal weight as a philosophy. We believe the strategy works around the world. Working with the index providers (Russell and MSCI), we have recently expanded our equal weight lineup to include: MSCI ACWI, EAFE and Emerging Markets, as well as Russell 1000, 2000 and Mid Cap. Our Russell equal weight ETFs, begin by equal weighting the sector first, 1/9th per sector, and then we equal weight the individual securities underlying the index.
ETFdb: So as a real life example let’s use the recent financial crisis. A cap weighted index would have shrunk its allocation to financials as share prices plummeted, whereas an index that equal weights across sectors would have maintained that allocation to financials and been in a better position to profit during the recovery. Is that how the rebalancing could potentially add value?
TD: Yes. Equal weighting helps in “boom and bust” by trimming positions over time. In the late 90s, the tech sector was roughly 35% of the S&P, equal weighting would have lagged on the way up, but protected better on the way down – when the bubble burst in 2000.
So as much as we believe in equal weight as a methodology, it will not always be the best performing strategy. There will be periods of time that it underperforms. We would argue that in a mega cap environment where the top 50 names are so dominant, we will lag. We will also lag if there is a boom period of time, because we will be trimming those positions over time. Our belief is that over the long run, we are more than rewarded for having a more disciplined process (see Guide To ETF Index Weightings).
ETFdb: Talking about weighting in general, it seems like there is a perception among investors that weighting is a very minor distinction that does not have a significant impact on the risk return profile. But looking at some of the numbers over the last few years, that is clearly not the case. Why don’t people grasp how big of an impact the weighting can have?
TD: It is a very big issue. In your year-end report, you noted that our equal weight S&P 500 ETF (NYSEARCA:RSP) outperformed the cap weighted S&P 500 ETF (NYSEARCA:SPY) by 600 basis points in 2010. That is a very sizable margin. As we have looked at the data we have seen pretty persistent results over time. So I think that weighting is indeed a very big decision. It also means that the portfolio might look very different too.
So again going back to this whole cap issue, looking at the S&P 500, it is very much a mega cap play. If you have an environment where smaller and mid-cap names are contributing more to the portfolio, you would expect to see some equal weight strategies outperform cap weight. And I think that was a big part of why we saw such a big delta; 600 basis points is certainly not something to take lightly. We think that what we have experienced here with the S&P 500 will translate into global strategies that we have looked at. In 2010, our MSCI equal weight emerging market index was roughly 600 basis points better than its cap weighted equivalent.
ETFdb: So RSP and SPY are two funds where the underlying holdings are identical, and the only difference is the allocation given to each?
TD: Exactly, it is the exact same holdings. We take the exact same 500 names, and we simply choose to more rationally allocate across all 500 rather than make big concentrated bets. We rebalance on a quarterly basis retaining the integrity of equal weighting.
ETFdb: Equal weighting isn’t the only alternative weighting methodology out there. Is it fair to group all these strategies together? Or are there some pretty significant differences between the "fundamental" weighting strategies as well such as equal weighting, dividend weighting, or fundamental weighting?
TD: There are some important differences. I think the average investor should understand how they are different. Ultimately, what the portfolio looks like at the end of the process, and then in what environments might they perform well and perform poorly. In our view, what is really great about equal weighting is not only the ability to pick up some of the returns from the small- and mid-cap names, but the disciplined rebalancing actually provides a little bit of a value/growth tilt depending on the market and the environment. Fundamental ETFs typically have a value tilt, emphasizing such factors as: price-to–book, price-to–sales, book value and dividends. These Fundamental strategies tend to be more value-oriented, so they will likely lag in a growth cycle.
It is important for the investor to understand what they are getting with cap weighted indexes. Cap weighted strategies are likely going to do pretty well in boom periods, and underperform during bust periods, because the companies that perform well will increase in weight in the portfolio. That is because cap weighted portfolios don’t rebalance - they actually reward large positions within the portfolio. While there are many ways of owning the market, it is important to understand what the underlying portfolio holds in what proportion, and how the returns will behave in a given market environment.
ETFdb: Let’s talk about emerging markets. We have seen that emerging markets have performed very well in recent years, and assets in emerging market ETFs have skyrocketed. So what is it about the marriage of emerging market exposure and the ETF vehicle that is so attractive to investors? Why are people using ETFs to access emerging markets in such large numbers?
TD: In our view, the emerging markets represents a very exciting opportunity. But for the average investor, there isn’t an efficient way of getting exposure to the markets. They likely don’t have the wherewithal to buy individual securities, and they do not have a lot of ways to evaluate the various means of getting exposure to the market. So if you believe the growth potential is there, the ETF is a very good way of getting that exposure. And if you wake up tomorrow and you don’t like the exposure, you could very easily unwind your position. I think ETFs provide a very efficient way of accessing a very exciting and diverse market for the average investor.
From the investment perspective, I still continue to believe that is the emerging markets represent an attractive opportunity. China is building roads and moving from the farms to the cities. With 1.3 billion people, they are consuming goods and services, and will likely continue to grow their economy in the coming years. Brazil is rich in natural resources, India is innovating with new technology, and Russia could, in fact, be a beneficiary of all of the disruptions in the Middle East. So if you think of those exciting market opportunities and you want to play in that market, I think investors have a number of different ways of getting exposure.
Investors can choose to buy individual securities, but it is difficult to evaluate individual securities. Investors can choose to buy individual countries, but they can be very volatile. So the country bets have some inherent risk, and the individual companies have some inherent risk associated with them.
We would argue the most important decision is getting exposure to the market in the first place. If you really believe that the goal in looking at an emerging market is to identify the next Apple (NASDAQ:AAPL), Google (NASDAQ:GOOG) or Baidu (NASDAQ:BIDU), the average investor doesn’t have the wherewithal to identify the companies. In our view, the most intelligent way of getting the exposure is to buy an ETF. And we think it is attractive to own the emerging market in an equal weight fashion because what you get is a broader diversification across the portfolio and the markets.
One of the things interesting to note, similar to our discussion about the S&P 500 where mega caps dominate the portfolio, the cap weighted emerging markets index is dominated by a number of multinationals. Samsung (OTC:SSNLF) is the largest name in the cap weighted equivalent index. South Korea, where Samsung is based, is sometimes viewed as a developed nation. Samsung is a multinational company that is more dependent on the U.S. for growth than they are on the emerging market. Multinationals may act and perform differently than the emerging market they come from.
ETFdb: We tend to agree. Many international ETFs are dominated by the multinationals that do business all over the world, and may be less of a “pure play” on the local markets. We have also seen that in many emerging market ETFs, there is a very large tilt toward financials and toward banks, just because that is what generally happens to be the largest companies in a country.
TD: The multinational impact is a factor, with the largest companies representing the biggest weights in the cap weight index. So, by equal weighting, you are spreading the risk, but also spreading the opportunities, and allowing smaller companies to contribute more to the portfolio.
ETFdb: We have seen huge growth in the ETF industry over the past several years, but from one perspective it is kind of surprising that the space isn’t bigger. What do you see as the biggest hurdles to growth, or the biggest issue you have to get people over when they are making the switch or are thinking about embracing ETFs?
TD: Personally, I am surprised that it is not bigger. The mutual fund industry is a roughly a $12 to $13 trillion dollar industry and ETFs are just over $1 trillion in AUM. I believe it is still early in the game, and there is still room to grow. We also believe that more and more people will continue to adopt ETFs. We are seeing changes in the behavior of the large wire house advisors who are adopting discretionary models and using ETFs to gain exposure to various asset classes. We are seeing a paradigm shift with advisors more broadly using ETFs in their asset allocation models.
For many years, the hedge fund and institutional communities have been big consumers of ETFs. We think it is still in the early innings and that there is a lot of growth to come. I think we will continue to see growth in the types of ETF strategies, and the number of advisors embracing them in their clients’ portfolios.
For the average investor, they can buy an ETF, a mutual fund, or they can choose to buy individual securities on their own. After 2008, a lot of advisors and individual investors determined, they can’t really do it on their own. If you evaluate a mutual fund relative to an ETF structure, there a couple of things that are important to consider. ETFs provide a cost-effective and tax efficient means of gaining exposure to virtually every asset class, and cost is a pretty big consideration in this environment.
We have started to see the growth of alternative weighting methodologies. Many of these strategies stack up well relative to both their cap weighted equivalents and comparable mutual funds. In fact, we have looked at our equal weight strategies relative to cap weighted equivalents, and the comparable Lipper universes. The data is pretty compelling. I think, more and more, you are going to see people adopt ETFs as the preferable way of owning the market. So some of the biggest hurdles overall are education and awareness.
ETFdb: Thanks for sharing your thoughts.
Disclosure: Long RSP.
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