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An Evolved Way To Play Domestic Stocks

ETF Professor

The S&P 500 is one of the world's most widely followed equity benchmarks. It's also easy to understand. Its components are weighted by market capitalization.

That means the largest U.S. company by market value, Microsoft Corp. (NASDAQ: MSFT) commands the biggest percentage in the index and so on.

What To Know

Market cap weighting is the dominant weighting scheme among index funds and exchange traded funds. Cap-weighted strategies are typically efficient and accurately reflective of a particular equity market, but there are drawbacks.

The strategy can sport significant factor bias while also exposing investors to overvalued stocks. A slew of alternative weighting methodologies seek to ameliorate the risks of weighting stocks by market value. One that is proving efficient in that quest is the Reverse Cap Weighted U.S. Large Cap ETF (CBOE: RVRS).

The methodology with RVRS is simple: the smallest members of the S&P 500 receive the largest weights in the fund.

Why It's Important

RVRS is not old. The fund debuted in October 2017, but data confirm the efficacy of the strategy. Over the past 12 months, RVRS is up 2.78 percent while the cap-weighted S&P 500 is higher by just 0.38 percent over that span.

Of the December market lows, RVRS “has returned nearly 14% in this short time period and even though the year is young, at the moment Reverse Capitalization Weighted indexing is out-performing traditional market cap indexing to the tune of more than 300 basis points,” said Paul Weisbruch, head of ETF sales and trading at Dallas-based Esposito Securities, in a recent note.

There is another reason to consider RVRS -- recent laggard status for the S&P 500's 100 smallest stocks, which underperformed in the past two years after being the best-performing subset in six of the previous nine years, according to Weisbruch.

What's Next

Critics often assert that size-driven strategies outperform large-cap funds because of, well, smaller size. Indeed, the average market value of RVRS components is smaller than the S&P 500's average market value, but by that metric, RVRS is also significantly larger than standard mid-cap funds.

“Another observation is noting that only about 10.65% of the entire portfolio of RVRS is spread across the top ten names in the basket, meaning that there is a great deal of diversification across the entire index as compared to something that may be considered heavily concentrated or top heavy,” said Weisbruch.

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