With all the attention being heaped upon smart beta and factor-based exchange-traded funds (ETFs), it is a fine idea to revisit one of the oldest iterations of non-capitalization weighted investing. That is equal-weight indexes and funds.
The equal-weight methodology is straightforward. Say a particular index starts with 100 stocks – the index provider will likely assign a weight of 1% to each component. A common criticism of equal-weight ETFs is that if a small number of stocks, particularly large-cap names, are driving the broad market or a specific sector higher, investors will not capture as much of that move as they would with a cap-weighted fund. (See also: S&P 500 ETFs: Market Weight vs. Equal Weight.)
The advantage of an equal-weight fund is that these products significantly reduce single stock risk. And that advantage does not mean investors sacrifice returns. For example, in the five years that ended 2016, the Guggenheim S&P 500 Equal Weight ETF (RSP) outpaced the cap-weighted S&P 500 in four of those five years. (See also: 3 ETFs That Beat the S&P 500.)
RSP is one of the largest, most popular equal-weight ETFs, but one of the genre's most unheralded names is the Guggenheim S&P 500 Equal Weight Financials ETF (RYF). RYF holds 64 stocks and tracks the S&P 500 Equal Weight Financials Index. Weights for the ETF's holdings range from 1.26% at the bottom to 1.74% at the high end.
Some research suggests that the primary reason equal-weight funds outperform cap-weighted equivalents is the size factor. What that means is that equal-weight ETFs essentially assign the same level of importance to their smaller (by market value) constituents as they do to large-cap names. The result is that, in strong bull markets when small-caps can potentially lead, equal-weight ETFs top cap-weighted rivals. (See also: 4 Cases Against Smart Beta.)
While RYF is not a dedicated small-cap fund, its composition is vastly different from its cap-weighted equivalents. For example, RYF devotes one-third of its weight to insurance stocks, but the Financial Select Sector SPDR (XLF), the biggest financial services ETF, has an insurance allocation of just 18.3%. Conversely, XLF's bank weight of 45.6% is 1,900 basis points higher than that of RYF.
Still, it is hard to argue with the results. Since the start of the current bull market, RYF is the best-performing sector ETF, although three industry funds rank ahead of it. Overall, just six non-leveraged ETFs have topped RYF since March 10, 2009. Over that period, RYF has delivered a cumulative return of almost 560%, according to Morningstar data. A $10,000 stake in RYF purchased on March 10, 2009, would be worth about $66,000 today. (See also: Different Approaches to Financial ETFs.)