Investors have been thrilled with the performance of equal-weight ETFs, but there is a flip side to every coin.
Equal weight strategies have become increasingly popular in the ETF world in recent years, with investors pouring billions into funds that institute a simple “twist” on traditional stock exposure. Led by the Guggenheim S&P 500 Equal Weight ETF (RSP), the results have generally been impressive; RSP has beaten the “simple” cap-weighted S&P 500 by nearly 150 basis points annually over the past decade.
Despite the sterling track record, however, this strategy isn’t the elusive free lunch for investors. There are some potential downsides that are worth examining.
Pitfall #1: Extra Risk
Whereas market capitalization gives the largest allocations to the most valuable companies, an equal weight approach gives the same allocation to each component of an index. In the case of the S&P 500, this means that the most valuable company (Apple) and the 500th most valuable company (Diamond Offshore Drilling) receive the same 0.20 percent weight. In a cap-weighted fund, Apple would account for about 20 times that amount of the total portfolio. (Note that there are currently 502 stocks in the S&P 500; this example assumes a simplified list of 500 stocks.)
In aggregate, this means that converting a cap-weighted index to an equal-weighted version will shift exposure from large-cap to small-cap stocks (i.e., from Apple to Diamond). In general, this means taking on some additional risk; small-cap stocks tend to be more volatile than large-cap companies.
While the correlation between large caps and small/mid caps is nearly perfect, the latter group tends to experience more extreme movements in both directions. In bull markets, this additional risk is generally positive. When stocks decline, however, small-caps can experience greater losses.
The following table compares the Guggenheim S&P 500 Equal Weight ETF (RSP) with the S&P 500 SPDR (SPY).
Equal weighting is essentially a shift toward small-cap and value stocks. Investors will be rewarded (and punished) accordingly depending on the relative performance of these styles.
Pitfall #2: Trend Is Not a Friend
Whereas cap-weighted products require little maintenance, equal-weight ETFs must regularly rebalance to return each component to its base equivalent allocation. Because there is variance among the individual stocks in a portfolio, the weightings deviate from the baseline immediately after a rebalance is complete. After a quarter of trading, the allocations within the portfolio will generally be distributed around the base weight.
The rebalance process essentially involves selling shares of the best performers and buying shares of the worst stocks in the benchmark — in other words, smoothing out the columns in the example above. There is a certain appeal to this process, especially to value investors; it is essentially a rules-based strategy for buying low and selling high.
But there are scenarios where buying the losers doesn’t end up being the optimal strategy. Specifically, an equal weight strategy will continue to buy shares of stock in free fall at each rebalance date. The chart below shows Avon Products (AVP) during the last five years; the stock has lost 75 percent of its value while the S&P 500 is up about 94 percent. An equal weight strategy would have bought more shares of AVP at nearly every rebalance.
Image Source: Yahoo! Finance
Since the beginning of 2010, AVP lagged the S&P MidCap 400 in 17 of 21 quarters, including seven straight at one point. Amid that prolonged period of underperformance, an equal weight fund would have continually increased the number of shares held when ideally it would have been selling (and while a cap-weighted fund would have kept a steady number of shares).
Conversely, an equal weight strategy will also sell shares of a surging stock when it rebalances. In some cases, a stock will be temporarily overvalued after a rally, and this discipline is rewarded. But when a stock is able to maintain its outperformance over an extended period of time, pruning the shares of the winner at every rebalance drags on a portfolio. Apple (AAPL) has outperformed the S&P 500 by nearly 75 percent over the last two years and has beaten the S&P 500 in six of the last seven quarters.
Image Source: Yahoo! Finance
Most equal weight strategies that rebalance quarterly would have sold AAPL shares at all but one quarterly rebalancing when a cap-weighted fund would have held a steady number of shares and increased the allocation.
The rebalancing mechanism in equal-weight products works both ways. In some cases, it will force prudent sales of overpriced stocks, while in others, it will cause investors to double down on losers or sell winners too soon.
Pitfall #3: Compounding Fees
Simply put, equal-weight ETFs are more expensive than their “plain vanilla” counterparts. Most equal weight ETFs cost between 20 and 40 basis points more than a comparable cap-weighted product, though the extra fees can get as high as 62 basis points for international exposure:
Data Source: Issuer Websites
While the differences in expenses may not seem substantial, these extra fees can erode returns when held for an extended period of time in a portfolio. In order to match the bottom line returns delivered to investors, equal weight strategies will need to outperform by 20 to 60 basis points annually; any alpha under that threshold will be wiped out by extra fees.
Equal weight ETFs have generally been a boon to investor portfolios; for the last several years, the benefit from a seemingly small tweak to stock exposure has enhanced returns in a meaningful way. While equal weighting will excel in some environments, it can — and will — struggle in others.