Equal weighting has a lot to like. It is perhaps the simplest smart beta strategy. There is no need for factors or optimization. And it has delivered performance. Guggenheim's S&P 500 Equal Weight ETF (NYSEARCA:RSP) returned 8.9% annualized since inception in 2003, handily beating the 7.2% return of its market cap weight competitor iShares Core S&P 500 (NYSEARCA:IVV). Proponents of equal weighting seem to think that it offers the free lunch of better returns and better diversification. However, much of the performance advantage over market cap weighting has come from slight overweights of value and mid-cap stocks.
To form an equal weight portfolio, one only needs to know the number, N, of securities in the parent index. The weight in the equal weight portfolio is then 1/N or 0.2% for the S&P 500. The below chart shows the weight of each stock in the S&P 500 in descending order by weight. Apple (NASDAQ:AAPL), the largest stock, is on the far left.
Because the weight of assets in a market cap weighted portfolio is skewed toward mega-cap stocks, smaller stocks have little impact on the portfolio. If we equal weight the S&P 500, we essentially have massive underweights to these mega-cap stocks along with small overweights to a hundred or so mid-cap stocks. For example, Apple is 3.3% of the S&P 500, but only 0.2% of the equal weighted portfolio, resulting in a 3.1% relative underweight. In contrast, mid-cap company UDR (NYSE:UDR), which makes up only 0.05% of the S&P, has a relative weight in RSP of 0.15%.
Some claim that equal weighting lowers concentration risk in individual stocks, but I would rather have a large portion of my assets in blue chip names, which tend to be of high quality, than in hundreds of lower quality stocks. The argument for better diversification when equal weighting falls flat when you look at the volatility of returns. RSP has had a volatility of about 16.2% compared to 13.6% for IVV.
The overweight to mid-cap stocks is evident in the Morningstar Style Box. The centroid is noticeably lower, indicating smaller size, for RSP than it is for IVV. All else equal, equal weighting will slightly underweight growth stocks selling at high multiples and overweight value stocks. This is why the centroid is slightly to the left, indicating deeper value, for RSP than it is for IVV.
A key feature of equal weighting is the rebalance. A market-cap-weighted portfolio never has to rebalance because stocks naturally rise in weight as their price appreciates. However, as a stock appreciates, it needs to be sold to maintain equal weights. This is a contrarian, buy low, sell high approach that may provide some alpha. RSP rebalances quarterly and had turnover of 22% last year compared to just 4% for IVV.
To examine the performance of RSP, we ran a regression against IVV, a proxy for the S&P 500. The results showed a beta of about 1.2 and an alpha of about 0.75% per year. So much of RSP's excess return came simply by taking more market risk than the S&P 500. Still, there was 0.75% per year of alpha. To break it down further, we ran a three-factor regression, comparing RSP to the market, small size and value factors. Compared to the S&P 500, RSP had more exposure to small size and value, as we would expect. This approach also led to a reduction in the fund's alpha from 0.75% per year to 0.47% per year. This is still good in light of the fact that most funds deliver negative alpha, and it could be even better if RSP would reduce its 0.40% expense ratio. After all, IVV charges just 0.04%. As a $12 billion fund, Guggenheim has no excuse for such a high expense ratio.
Equal weighting the S&P 500 provides tilts away from mega cap and growth stocks and toward smaller cap and value stocks. By taking on size and value risk, investors should demand higher returns from an equal-weighted strategy. The contrarian rebalance may also provide some alpha. Investors would benefit from a lower expense ratio on RSP.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.