Given the growing number and popularity of ETFs—and given their reputation as a low-cost tool for diversification—it’s important to understand how these investments track the indexes they represent. You may have an ETF that invests in the S&P 500, the Nasdaq 100, or the Russell 2000. But that doesn’t necessarily mean you’re sufficiently diversified in 500, 100, or 2000 securities. Why? It all comes down to weighting.
A recent article in ThinkAdvisor’s Research magazine identifies three basic approaches to weighting an index:
- Market capitalization weighting
- Equal weighting
- Weighting that uses one or more other factors, such as earnings or dividends
The S&P 500 is one example of a market-cap weighted index. In other words, its component securities are weighted according to the actual market value of their shares. As a result, over 30% of the index’s value is determined by its top 25 holdings. The other 475 holdings drive only 69% of the index’s value. It’s impossible to say how many investors fully understand this weighting issue, but one thing is certain: an investment in the S&P 500 index is not a diversified investment.
But ETF providers have been innovating their products to give investors more choices. One such innovation is the equal-weight index. Rather than weighting companies by market cap, equal-weight indexes give all stocks within the index the same weighting, as the name implies. The obvious question is how this indexing method stacks up in terms of performance against traditional market-cap weighted indexes. The answer depends on the index. Recent research indicates that over the past decade, an equal weight index of the S&P 500 has gained 143% versus a gain of only 118% for the traditional S&P 500.
One explanation for this discrepancy in return is that equal-weight indexes push a greater percentage of the index weighting into smaller capitalized stocks, causing investors to take on more risk in exchange for a potentially higher return. A study from Research Affiliates points out that equal weight investors take on more volatility but have largely been rewarded for that.
Another possible contributor for equal-weight outperformance revolves around the tendency of market-cap indexes to overweight overpriced stocks. As the price of a stock in the S&P 500 grows, so too does its weighting within a market-cap weighted index. That can lead to investors reducing exposure to stocks that are potentially on sale and instead buying into momentum.
Despite the optimistic results that have come out of many equal-weight indexes, there are some concerns as well. For one, managing an equal-weight index is somewhat more complicated and potentially less tax efficient than managing a market-cap weighted index. And it requires constant rebalancing, which causes an increased turnover rate, in order to maintain equal weighting of the companies. You wouldn’t have that issue with a market-cap weighted index, which strives to reflect the natural movement of stock prices, rather than rebalance away from it.
There are also performance issues with equal weighting in many parts of the market. While the equal weighted S&P 500 numbers look good, an equal weighting variety of the Russell 1000 and Russell 2000 over the past 12 months are trailing their market-cap counterparts by quite a bit. And once you factor in the typically higher cost of holding equal-weight indexes over market-cap indexes, you may encounter further skepticism about the long-term viability of the strategy.
Time will tell whether these innovative ETFs ultimately have staying power. At the very least, they pose an interesting value proposition as potential building blocks for diversified portfolios for investors who may have concerns about market-cap weighted indexes.
 Delegge, Ronald: "Exchange-Traded Product Report": Research Magazine, May 2015. Based on performance of RSP and SPY as of April 30th, 2015.
 RSP vs. SPY expense ratios as of June 15th, 2015 = 0.40% vs. 0.09% according to Yahoo Finance.