Are Your Cap-Weighted ETFs Leaders Or Laggards?

by on July 13, 2010 | ETFs Mentioned:

The rapid growth of the ETF industry in recent years has altered the investment landscape in more ways than one. The low expense ratios offered by most exchange-traded products have brought increased scrutiny on active managers and called into question their ability to add value to client portfolios. The immediate diversification offered by a basket of securities has caused some to shift away from the complex research associated with individual stock picking towards more macro analysis required for tactical strategies. And as indexes have evolved from hypothetical measures of performance to essentially investable assets, the methodologies utilized in the construction and maintenance of benchmarks have become increasingly important to investors [see our database of ETF indexes].

The first generation of equity ETFs was dominated by market capitalization-weighted strategies, a methodology that involves assigning a weight to each component based on the total value of its equity. Most of the assets in equity ETFs can still be found in cap-weighted funds, but that strategy is no longer the only game in town. In recent years, a number of alternative weighting strategies have become popular with investors, including:

  • Equal Weighting: An equal-weighted index holds an equal dollar amount of each of the component companies. This technique requires regular rebalancing because the value of stocks shift, causing a change in the security’s individual weighting.
  • Earnings Weighting: This methodology determines the appropriate asset allocation based off of a company’s reported earnings. Companies with higher earnings will have higher weightings in the index. The technique may have a tendency to be heavy in value stocks, avoiding companies with negative earnings (many growth companies have negative earnings).
  • Dividend Weighting: Like the earnings-weighed index, this strategy gives its highest allocation to the security that has paid out the highest cash dividends. There are a number of potential advantages to this strategy, including an avoidance of firms that engage in “cooking the books.”
  • Revenue Weighting: This strategy involves weighting each component by top-line revenue, a technique that overweights low price-to-revenue companies and underweights companies with a high price-to-revenue ratio [see Revenue-Weighting: A New Twist On An Old Drink].

With the first half of 2010 in the books, we take a look back to see which of these strategies have performed the best through the first two quarters of the year. Two words of caution; first, while the components of the ETFs profiled are generally very similar, they won’t always be identical. As such, the weighting methodology isn’t the only variable (although it is definitely the primary difference within each group below). Second, the tables show results over a six-month period, a time frame that isn’t long enough to draw any definitive results. Still, the results are very interesting, and demonstrate that a tweak to weighting methodologies can have a material impact on bottom line returns.

Large Cap Equities

Considering that SPY is the largest ETF by total assets, it isn’t surprising that there have been a number of “spin off” funds that hold similar components but utilize different weighting strategies [see Nine Alternatives To SPY]. But it has lagged behind other large cap funds with similar holdings but different weighting methodologies through the first half of the year:

Ticker ETF Methodology 1H ’10 Return
RSP Rydex S&P Equal Weight ETF Equal -4.4%
RWL RevenueShares Large Cap Fund Revenue -5.8%
DLN WisdomTree LargeCap Dividend Fund Dividends -6.0%
EPS WisdomTree Earnings 500 Fund Earnings -6.7%
SPY State Street SPDR S&P 500 Fund Market Cap -6.9%
All returns as of 6/30/2010

The winner: None of these ETFs has delivered particularly impressive returns, but the equal-weighted index has not experienced as rough of a beating year-to-date.

Mid Cap Equities

An equal-weighted ETF is not offered in the mid cap equities though there are a number of ETFs offering mid cap exposure. Each of these ETFs offers exposure to mid cap equities, with the primary difference being the methodology utilized to determine individual weightings.

Ticker ETF Methodology 1H ’10 Return
DON WisdomTree MidCap Dividend Fund Dividends -0.6%
EZM WisdomTree MidCap Earnings Fund Earnings -0.9%
IJH iShares S&P MidCap 400 Index Fund Market Cap -1.5%
RWK RevenueShares Mid Cap Fund Revenue -4.4%
All returns as of 6/30/2010

The winner: Again, the market cap-weighted ETF lagged behind other strategies, as dividend weighting and earnings weighting were the most effective strategies among mid cap ETFs.

Small Cap Equities

Small cap equities have been among the best performers of the year, but not all funds have turned in equivalent performances:

Ticker ETF Methodology YTD Return
DES WisdomTree SmallCap Dividend Fund Dividends 2.8%
IJR iShares S&P SmallCap 600 Index Fund Market Cap -0.9%
EES WisdomTree SmallCap Earnings Fund Earnings -1.0%
RWJ RevenueShares SmallCap Fund Revenue -1.8%
All returns as of 6/30/2010

The winner: The dividend-weighted ETF blew the other methodologies out of the water, claiming bragging rights as the only small cap fund to finish the second quarter in positive territory for the year.

Results

Market cap weighting is the most widely known and used technique in constructing equity indexes. But many investors have embraced alternatives to cap-weighting, adopting strategies that use other fundamental factors to determine the allocation given to individual holdings. As demonstrated above, the choice of weighting methodology can have a pretty big impact on bottom line returns, and can sometimes be the difference between positive and negative territory.

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Disclosure: No positions at time of writing.