Over the past several years there’s been a lot of derogatory talk against traditional market cap weighted indexes.
And one of the oft-repeated arguments against traditional indexing that you’re guaranteed to read about or see is something like, “Market cap weighted indexes overweight overvalued large-cap stocks and underweight undervalued smaller-cap stocks.” As a result of these arguments, there’s been a relentless crusade to demonize the “imperfections” of traditional indexes, which like it or not, still represent hard to beat market performance.
Funds and ETFs linked to equal-weight indexes are one example of an alternative indexing strategy that is often sold as a superior choice to traditional market cap weighted funds. Is it true?
Below, I plotted the performance of the Guggenheim S&P 500 Equal Weight ETF (NYSEARCA:RSP) versus its market cap weighted cousin, the SPDR S&P 500 ETF (NYSEARCA:SPY). As you can see, since 2003, RSP has gained +255% compared to just a +199% gain for SPY. On the surface, it appears that RSP is the superior S&P 500 ETF. But is it really so?
RSP takes each stock within the S&P 500 and assigns it an equal weighting of 0.20% within the index. (0.20% weight x 500 stocks = 100% allocation) This approach neutralizes the influences of larger stocks. That means smaller companies like CarMax, Exelon, and Freeport-McMoran have the same 0.20% weighting as mega-cap stocks like Apple, Microsoft, and Johnson & Johnson. In a traditional S&P 500 market cap weighted setting this sort of effect would never occur because only the largest stocks dominate the performance and behavior of the index.
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The Direxion NASDAQ 100 Equal Weight ETF (NYSEARCA:QQQE) uses a similar approach to RSP, but applied to the NASDAQ-100 index (NasdaqGM:QQQ).
Since it’s inception in 2012, the equal market cap weighted QQQE has underperformed the traditional market cap weighted QQQ by 7.7%. This doesn’t necessarily prove that QQQE is inferior, but rather shows that equal weighted indexes do in fact have biases. And these biases tend to mimic traditional cap weighted mid-cap (NYSEARCA:VO) and small-cap indexes (NYSEARCA:IJR).
Our next chart illustrates my point. It plots RSP versus the SPDR MidCap S&P 500 ETF (NYSEARCA:MDY). Although each respective ETF holds completely different stocks, both funds are highly correlated. It’s mainly because the effect of equal weighting the S&P 500 gives it a similar return profile to a market cap weighted mid-cap ETF.
Other mid-cap ETFs like the Schwab U.S. Mid-Cap ETF (NYSEARCA:SCHM) charge less than both MDY and RSP for similar exposure. The cost of SCHM is five times less or just 0.07% annually compared to RSP’s 0.40% annual fees. In other words, paying 0.40% for an S&P 500 equal-weight fund is an expensive proposition compared to less expensive market cap weighted mid-cap ETFs that offer a similar return path.
In summary, equal-weighted indexes are not bias-free because they introduce their own set of biases. If smaller stocks, for instance, are in favor and outperforming, the biases of equal-weighting will look smart. But if smaller stocks are out-of-favor and underperforming relative to the rest of the stock market, the results of equal-weighting will likely be inferior to traditional market cap weighted indexes.
Finally, the same rules apply to so-called “smart-beta” ETFs, which like equal weighted benchmarks, have their own unique biases. In other words, any out or under-performance of these new breed ETFs against traditional market cap weighted index benchmarks is 100% attributable – not to revolutionary paradigms or genius index manufacturers – but rather, to the popularity (or lack of it) to the distinct biases of the underlying index.