The equal-weighted indexing strategy is a simple alternative to market-cap weighted indices and can be a good way to gain a tactical position within a portfolio. The equal weight strategy can be used in exchange traded funds and gives each stock the same weighting within the portfolio.
“Exchange-traded funds are often used to make short term, tactical bets on certain sectors. In this case, you want exposure to an entire industry, not just to a handful of mega-cap stocks. Equal-weighted sector funds, such as Guggenheim S&P 500 Equal Weight Energy (RYE - News) may make more sense when seeking industry exposure,” Michael Rawson wrote in a recent Morningstar article. [How Equal Weight ETFs Can Protect a Portfolio]
The equal weighting strategy gives both small and large-caps an equal-weighting within an index fund or portfolio. This allows all of the companies to be considered on an even playing field.
Equal-weighted index funds tend to have higher stock turnover than market-cap weighted index funds and, as a result, they usually have higher trading costs, reports Investopedia. [ETFs and Indexing: What's Your Style?]
An equal weighted methodology is considered an alternative form of indexing, with the basic market-cap weighted index being the most common. There are risks associated with equal weighting, such as the potential for concentration in a handful of stocks within sector funds. Additionally, equal weighted ETFs are intended for use as a tactical holding, rather than used as a core holding within a portfolio. [What is an ETF? - Part 2: Indexing]
Michael Rawson for Morningstar reports that there are three potential sources of extra return from an equal weight index. There is a small size tilt from under-weighting mega-cap stocks and over-weighting smaller stocks. Also, there is a value angle from under-weighting overpriced glamor stocks. The third potential source of return is from contrarian re-balancing. In order to maintain equal weightings, the index must sell stocks that have recently appreciated and buy stocks that have recently declined. [ETFs Drive Innovation in Index Construction]
Overall, an equal weight index is known to perform better when the market favors small or mid-cap stocks. An equal weight index also avoids excessive valuations, when the market is driven by momentum.
Equal Weight ETFs:
- Guggenheim S&P Equal Weight ETF (RSP - News)
- Guggenheim S&P EQual Weight Technology (RYT - News)
- First Trust NASDAQ 100 Equal Weight Index Fund (QQEW - News)
Tisha Guerrero contributed to this article.
Read the disclaimer; Tom Lydon is a board member of the funds for Guggenheim Investments.