Who Else Wants A Better S&P 500 ETF?

by on March 5, 2010 | ETFs Mentioned:

As the popularity of ETFs has surged in recent years, so too has the number of funds available to investors. With well more than 900 exchange-traded products listed on U.S. exchanges, some have speculated that the ETF industry has “gone into absolute overdrive”, and that the wave of new product launches that continues to wash over the space is unsustainable.

Claims of saturation in the ETF industry have some merit. In recent years, ETF issuers have rushed products to market under the assumption that exposure to a unique market or sector would result in sufficient demand. There are more than 250 ETFs with less than $20 million in assets, many of which have been around for several years. The economics of an industry that has boomed in large part because of ultra-low expense ratios are challenging, meaning that for many of these smaller ETFs, the days are numbered.

But there are a lot of good ideas out there that haven’t been executed. Last month, we lamented that there is still no exchange-traded product offering targeted exposure to either the domestic or international automotive industry (the most effective play may actually be through platinum and palladium ETFs). This month, we make a case for the ultimate equal-weighted ETF as a potential alternative to cap-weighted products that dominate so many investor portfolios.

RSP + EQL = ???

http://etfdb.com/wp-content/uploads/2010/02/Weighting-Methodologies-Are-Extremely-Important.jpgWhile the bulk of equity ETF assets are in funds that are linked to market capitalization-weighted benchmarks (such as the S&P 500 or Russell 3000), a number of products offering alternative weighting methodologies have popped up as well (see a closer look at all of these strategies here). The Rydex S&P Equal Weight ETF (RSP) is one fund that has seen its popularity surge, nearly tripling its assets over the last year. RSP tracks the S&P Equal Weight Index, which includes all constituents of the S&P 500 in equal weights. As such, RSP is (to some extent) “market cap blind” in that it isn’t dominated by a handful of mega-cap equities. Moreover, an equal weighting methodology avoids the primary drawback of cap-weighting: the tendency to overweight overvalued stocks and underweight undervalued stocks.

Another interesting fund is the Equal Weighted Sector ETF (EQL), which invests in equal proportions in the nine Select Sector SPDRs. So the allocation to energy is the same as the weight given to technology, industrials, and materials. By giving an equivalent allocation to each sector, EQL limits the extent to which a crash in a specific part of the economy (such as technology in the early 2000s or financials in 2008) adversely impacts value. Moreover, this strategy provides the opportunity to participate in a rally in sectors ignored by the S&P 500 (such as materials, telecom, or utilities, which each account for less than 5% of the S&P 500). See Why EQL May Be A Better S&P 500 ETF Than SPY for more on this fund.

Both of these strategies have some clear advantages over traditional cap-weighted ETFs that . So why not combine the two to make the ultimate equal weighted S&P 500 ETF? Each sector would be given an equal weight (a la EQL) and component companies within each sector would be weighted equally as well (a la RSP). Constructing such an ETF wouldn’t be all that challenging, as Rydex already offers a line of nine equal-weighted sector funds. But it could potentially be a big hit with investors looking for an alternative to SPY.

For more ideas on potential additions to the ETF universe, see Ten ETFs Than Don’t Exist, But Should. For more insights into the ETF industry sign up for our free ETF newsletter.

Disclosure: No positions at time of writing.