When it comes to choosing which ETF is right for you, one of the top considerations of many investors is how exactly the fund's underlying index is constructed. Selection and weighting methodologies vary drastically from fund to fund, with the differences often making significant impacts on bottom line returns. Traditional marketcapitalization weightings were once the only game in town, but in recent yearsalternative-weighting methodologieshave become more popular among investors who find flaws in a strategy that gives the most weight to the biggest companies . And while there are numerous alternative methodologies, the most popular among investors is perhaps the equal-weighted approach, which seeks to mitigate the downside effects of a fund being dependent on only a handful of stocks. A comparison of traditional cap-weighted and equal-weighted ETFs reveals some factors investors should be mindful of.
Does Weight Really Matter?
While identifying the merits and disadvantages of each weighting methodology, investors often focus only on bottom line returns. Though this factor is certainly essential, it is also important to take a close look at the actual portfolio composition and the resulting risk profile the fund exhibits. Many argue that equal-weighted ETFs are less volatile, since they do not solely depend on the performance of only a few individual securities. Critics of the methodology, however, argue that the upside potential is significantly diminished since not enough weight is given to large-cap stocks, which typically provide more stable returns .
The chart below highlights both traditional cap-weighted and equal-weighted S&P 500, EAFE and emerging market funds, revealing the differences between the historical performances, portfolio size and portfolio concentrations:
- SPDR S&P 500
- S&P Equal Weight ETF
- MSCI EAFE Index Fund
- MSCI EAFE Equal Weight ETF
- Emerging Markets ETF
- MSCI Emerging Markets Equal Weight ETF
Perhaps the most surprising observation is the comparison of EWEM and VWO; the cap-weighted fund seems to cast a wider net over the emerging market space, and actually allocates less to its top ten holdings than does its equal-weight counterpart. In addition, VWO managed to eke out a small gain over the trailing one-year period, while EWEM suffered minor losses.The equal weighted EWEF fund also trailed behind EFA, while the cap-weighted SPY did not perform as well as RSP .
Though this comparison is only based on one-year historical returns, it is important for investors to take a close look under the hood of the various weighting methodologies, as differences often have a material impact on bottom line returns.
Disclosure: No positions at time of writing.