The world of indexing is typically dominated by market capitalization weighted methodologies that give the largest allocation to the biggest stocks. However, that can often lend itself to these mega-companies having too great of a pull on the performance of the overall strategy.
For example, the PowerShares QQQ Trust, Series 1 (NASDAQ: QQQ) tracks the 100 largest non-financial stocks on the NASDAQ stock exchange using a market cap weighted approach. The largest holding in QQQ is Apple Inc. (NASDAQ: AAPL), which accounts for 14 percent of the total assets. Apple is therefore in a position to significantly influence the total return of the fund.
A varying style to the market cap index is an equal-weighting methodology that gives every stock in an established index a proportionate share of the asset allocation. This allows for smaller companies to have a more pronounced impact on the total return of the fund.
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The First Trust NASDAQ-100 Equal Weighted Index Fund (NASDAQ: QQEW) is the equal-weighted peer of QQQ and owns the same underlying 100 stocks. Each stock within the index is given a 1-percent allocation of the total assets and rebalanced on a quarterly basis.
So far this year, QQEW has slightly underperformed the benchmark index because of the generous returns of mega-cap stocks such as Apple and Microsoft. However, this could certainly change if the largest companies started to lag their smaller competitors.
Equal-weight ETFs typically shine during market cycles that favor smaller companies within the same industry group or sector.
The most well-known equal-weight index is the Rydex S&P 500 Equal Weight ETF (NYSE: RSP), which has more than $9.1 billion in total assets. Interestingly enough, RSP is moving almost in lock step with its market cap equivalent SPDR S&P 500 ETF (NYSE: SPY) this year. Both ETFs have gained approximately 10.5 percent since the beginning of 2014.
While the equal-weight methodology hasn't had a significant impact on total return this year, in past instances it has added notable outperformance. Last year for instance, RSP added more than 3 percent in additional return versus SPY.
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