In the world of investing, tradition is king, and lengthy histories carry significant weight with an investing public that is surprisingly entrenched in its ways. As creatures of habit, investors are slow to part with familiar strategies and metrics that have lengthy histories. Take the Dow Jones Industrial Average, for example. The “Dow” has several major flaws as an index (it’s a price-weighted benchmark composed of 30 mega-cap equities), but it is one of the widely-followed numbers in the world and is held out as a barometer of U.S equity performance by everyone from major Wall Street banks to local newspapers.
It is another well-known benchmark, the S&P 500, that serves as the basis for the SPDR S&P 500 ETF (SPY), the largest U.S.-listed ETF by assets. But the popularity of S&P 500 ETFs (iShares offers the competing IVV) is perhaps due more to investor familiarity than the merits of the underlying investment thesis. Like most indexes underlying popular ETFs, the S&P 500 is a market capitalization-weighted benchmark, meaning that the individual allocation given to each stock is determined by the company’s size. Cap weighting has some advantages–it reduces the frequency and significance of rebalancings–but also some major drawbacks. Most notably, a cap weighted system will tend to overweight overvalued companies and underweight undervalued companies, thereby creating a return drag.
The rise of the ETF industry has brought increased focus to the methodologies behind indexing strategies, and led to some exciting innovations as well. The Rydex S&P Equal Weight ETF (RSP), for example, weights each component of the S&P 500 equally. Since its inception in 2003, RSP has gained about 64%, compared to only 34% for SPY.
Sector Weighting Issues
Another potential flaw of S&P 500 ETFs relates to the allocations these funds give to individual sectors of the economy. Since the S&P 500 consists of the largest 500 companies by market capitalization, the sector breakdown is somewhat arbitrary. If the largest companies are concentrated in a particular sector, the index will tilt towards certain industries and away from others. This can lead to some undesirable effects. “Over the last 30 year the largest annual declines in the S&P 500 have been precipitated by a crash in the market’s largest sector,” said Jeremy Held, director of investment strategy and research for ALPS. “In 1981, it was Energy stocks. In 2000, it was Technology. Most recently it was the Financial sector. An equal sector strategy can minimize the negative impact of any one sector on the entire portfolio.”
In July 2009, ALPS launched the Equal Sector Weight ETF (EQL), a fund that offers exposure to the large cap equity market by investing in equal proportions in each of the nine Select Sector SPDRs. So the allocation to energy is the same as the weight given to technology, consumer staples, and industrials. SPY, on the other hand, features some significant weighting discrepancies: technology and telecom accounts for about 22% of the fund, while materials makes up just 3%.
There are several potential advantages of an equal sector allocation. The potential adverse impact of a crash in any one industry is lessened somewhat, while the opportunity to participate in a rally in any sector is improved. Moreover, an equal sector weighting enhances the diversification benefits of investing in a large basket of underlying securities.
Although EQL is a relatively new product, the historical returns of the strategy behind the fund are readily available. In 2009, the equal sector strategy delivered a return of 27.1%, slightly better than the 26.5% for the S&P 500. What’s more interesting though is that 2009 marked the tenth consecutive year that such a strategy beat the S&P 500, a remarkable string of consistent outperformance. According to ALPS, the equal sector strategy gained almost 33% during that period, compared to a 9% loss for the S&P 500.
Disclosure: No positions at time of writing.