In recent years, advisors have undoubtedly become more acquainted with alternative or “smart beta” weighting schemes among exchange traded funds.
To adequately address the phenomenon is another piece unto itself, but the quick explanation is these products employ weighting methodologies other than market capitalization. One of the tried and true alternatives to weighting stocks by market value is equal weighting.
As the term implies, the components in equal-weight fund are, well, equally weighted. For example, an equal-fund with 100 holdings assigns weights of 1% apiece to those components when the fund is constructed and upon rebalancing. Easy enough for clients of all experience levels to comprehend.
Advisors know that the equal-weight methodology isn’t gimmicky. It’s just one example, but the Invesco S&P 500 Equal Weight ETF (NYSEARCA:RSP), the largest ETF in this category, is more than 19 years old and has $34.32 billion in assets under management. More important than those superficial metrics, RSP has a lengthy history of outperforming cap-weighted S&P 500 funds.
Concentration Risk Highlights Equal-Weight Perk
Perhaps the most obvious benefit of equal-weight strategies is diminished concentration risk – an alluring selling point at a time when supposedly diversified cap-weight broad market funds are heavily allocated to a small number of stocks.
That’s the case with the S&P 500 today and that could mean now is an appropriate time to discuss equal-weight strategies with clients.
“Using the historical adjusted HHI (Herfindahl-Hirschman Index), we’ve previously established that concentration tends to mean-revert in most sectors. Changes in concentration affect the relative performance of the equal-weighted versions of each sector,” notes S&P Dow Jones Indices. “Equal-weighted sectors tend to outperform after peaks in their sector concentration. This is particularly noticeable for Information Technology.”
Translation: Eras of high concentration in sectors often give way to out-performance by equal-weight strategies. That’s happening this year as the aforementioned RSP is beating the cap-weighted S&P 500 nearly 220 basis points.
“Changes in equal-weighted relative performance and changes in concentration are not two separate things, but two aspects of the same thing,” adds S&P Dow Jones. “If larger stocks outperform smaller ones, concentration will increase, and equal weight will underperform. Similarly, if smaller stocks outperform, concentration will decrease, and equal weight will outperform.”
Speaking of small caps, elevated exposure to that group is often cited as a reason for equal-weight outperformance, but in the case of RSP, it’s really about “smaller” stocks not small caps as the fund over 57% of its weight to mid-cap names and less than 1% to small-cap equities.
Sector Decisions Are Important Today
Specific to sectors, the current landscape indicates some are more conducive to equal weighting while cap weighting is the way to go in other groups.
“Since Information Technology and Consumer Discretionary’s adjusted HHIs are at historically high levels, equal weighting within these sectors might be worth considering rather than cap weighting, since concentration tends to mean-revert over time,” concludes S&P. “In contrast, the adjusted HHIs for Energy, Industrials and Materials are at historically low levels. This means that cap-weighted sector strategies could be beneficial if these currently low concentration levels move upward.”
Fortunately, there are equal-weight sector ETFs with which to play these trends.