Inside Some Benefits of Equal-Weight ETFs

Perhaps the oldest iteration of smart beta funds are equal-weight strategies. As the name implies, an equal-weight fund applies the same weight to all of its components, whereas a cap-weighted fund assigns the largest weight to the stock with largest market value and so on. For example, an equal-weight exchange-traded fund (ETF) that has 100 stocks will, in most instances, assign a weight of roughly 1% to each of its holdings when that ETF rebalances.

Today, there are hundreds of equal-weight ETFs trading in the U.S., but the dominant name among those products remains the Guggenheim S&P 500 Equal Weight ETF (RSP). The $15.6 billion RSP, which debuted in April 2003, was rated by Morningstar "based on its risk-adjusted returns, 3 stars for 3 years, 3 stars for 5 years, 4 stars for 10 years, and 4 stars Overall out of 1217, 1079, 800, and 1217 Large Blend funds, respectively," according to Guggenheim. (See also: A Venerable Equal-Weight ETF.)

Over the years, equal-weight funds have gathered followings among investors because, historically, a small number of securities drive equity market returns in any given year, and heading into any given year, no one knows what the leading stocks will be. "The first point – the skewness of market returns – is clear in historical data," said S&P Dow Jones Indices. "In 23 out of the past 27 years, the median stock in the S&P 500 has underperformed the return of the average stock. We see similar results in other markets. And if the second point were not true, we would not observe consistent underperformance from active managers."

Since inception, RSP has returned 386.2%, including paid dividends, while the cap-weighted SPDR S&P 500 ETF (SPY) has returned 292%. Critics often assert that any outperformance offered by smart beta strategies is attributable to the size or value factors. In the case of RSP, it would be the size factor because, as an equal-weight ETF, the fund places more importance on smaller stocks than the cap-weighted version of the S&P 500. (For more, see: S&P 500 ETFs: Market Weight vs. Equal Weight.)

Increased emphasis on small caps could imply increased volatility, but RSP's  annualized volatility since inception is only 170 basis points higher than SPY's. "To be sure, equal weighting does not always lead to success," said S&P Dow Jones Indices. "For example, 2017 was an outlier, as the S&P 500, driven by a handful of large technology stocks, outperformed the S&P 500 Equal Weight. But the equal-weighted index has outperformed in 16 of the past 28 years, by an average margin of 1.5% annually. One reason for this record is the ability of equal-weight indices to take advantage of the positive skew in stock market returns."

From 2012 through 2017, RSP trailed SPY just twice – in 2015 and 2017. (For additional reading, check out: An Equal-Weight ETF at a Lower Fee.)