Investigating the Effectiveness of Equal-Weight ETFs

When it comes to smart beta strategies, few are as old or as popular as equal weight. As the term implies, equal weight means assigning the same weights to each component in a particular index. For example, a hypothetical exchange-traded fund (ETF) that equally weights its 100 holdings would assign a weight of 1% to each at the time the fund rebalances.

Today, there are dozens of equal-weight ETFs trading in the U.S., tracking broader equity indexes as well as sectors and other assets. Home to $14.95 billion in assets under management, the Guggenheim S&P 500 Equal Weight ETF (RSP) remains one of the largest such ETFs. RSP, which follows the S&P 500 Equal Weight Index, turns 15 years old in April. (See also: A Venerable Equal-Weight ETF.)

"Equal weight investing is a smart beta strategy that does exactly what its name implies – it equally weights every stock in the strategy regardless of its market capitalization," said S&P Dow Jones Indices. "In contrast to traditional cap-weighted approaches – where each stock is weighted based on its size (or market capitalization), potentially resulting in increased concentration risk – equal weight investing creates unbiased exposure to all stocks. No one stock is more important than any other."

Critics of smart beta ETFs say any outperformance offered by these funds is usually attributable to the value factor or the size factor, the latter of which would be the relevant criticism of equal-weight funds because of the increased importance of smaller stocks. Perhaps the size factor criticism has some merit, but it does not mean that RSP is more volatile than its cap-weighted rivals. RSP has a standard deviation of 10.2%, roughly the same as the cap-weighted version of the S&P 500. (For more, see: Inside Some Benefits of Equal-Weight ETFs.)

Outperformance offered by RSP (the ETF has returned nearly 391% since inception in April 2003 compared with "just" 303.2% for the cap-weighted S&P 500) could be more attributable to effective rebalancing, which allows RSP to do what many investors are taught to do: buy low and sell high "Disciplined rebalancing may also contribute to outperformance for equal weight strategies, as equal weight allocations are regularly rebalanced back to their equal weight status," according to S&P Dow Jones. "This dynamic approach eliminates emotional attachment to stocks that experience price run-ups and offers a contrarian perspective via a buy low/sell high discipline."

Of course, equal-weight strategies help reduce investors' dependence on a small number of stocks, meaning that those investors are truly diversified. Consider this: at the end of 2017, 50 stocks combined for 49% of the cap-weighted S&P 500, but 238 stocks combined for the same percentage of RSP's underlying index. (For additional reading, check out: An Equal-Weight ETF at a Lower Fee.)