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Reducing Stock-Level Risk With Equal-Weight Funds

This article was originally published on ETFTrends.com.

Equal weight, the index methodology that assigns approximately the same weights to all of the benchmark's components, is one of the oldest iterations of smart beta and remains popular with advisors and investors today.

The biggest and most popular ETFs on the market largely include those that track traditional market capitalization-weighting methodologies, or they weight component stocks based on the companies’ market capitalization, so bigger companies have a greater say in the direction of the overall ETF’s performance.

In contrast, an equal-weighted indexing, like its naming suggests, would equally distribute the weight among all company holdings within the index, regardless of the market cap of each company.

The Invesco S&P500 Equal Weight ETF (RSP) , one of the dominant names among equal-weight ETFs, has consistently outperformed cap-weighted S&P 500 ETFs.

“An alternative to market-cap weighting is equal weighting.  If this index were reshuffled into an equal-weight structure, Facebook — just like each of the other holdings — would have a 3.85% weight in the index,” said Invesco in a recent note. “If that were the case, Facebook’s late July loss would have had much less of an impact on the overall index. The index would have fallen 3.23% from July 25 to July 30, with Facebook representing 25.41% of that loss.”

Another Idea for Equal-weight ETFs.

The PowerShares Russell 1000 Equal Weight Portfolio (EQAL) is another idea among broad market equal-weight ETFs.

The methodology that backs EQAL’s underlying index also mandates that the share portion of a potential constituent in a notional $5 billion portfolio cannot exceed 5% of the company’s float, ensures liquidity and that the benchmark remains investable. EQAL “is equally weighted across nine sector groups with each security within the sector receiving equal weight,” according to Invesco.

EQAL is up 45.40% over the past three years.

“Investors in market-cap-weighted indexes may not be quite as diversified as they think they are, due to concentration risk. Equal weighting is a potential solution,” said Invesco.

For more information on the equal-weight indexing methodology, visit our equal-weight ETFs category.