Thanks in part to the rise in popularity of exchange-traded funds in recent years, debate over the relative merits of various strategies for building and maintaining indexes has intensified considerably. The ETF boom has accelerated the transformation of benchmarks into investable assets, prompting investors to consider the impact of index nuances on the risk/return profile of their ETF investments.
Many of the most popular ETFs are linked to market capitalization-weighted indexes that assign the largest weightings to the most valuable companies. But despite the widespread use, cap weighting has repeatedly come under attack as a flawed means of achieving equity exposure–an argument that has some investment heavyweights on both sides.
The growth in ETF usage has also given investors multiple alternatives to market cap weighting. In addition to active ETFs, investors have the choice of products linked to indexes that employ dividend-weighted strategies, revenue-weighted techniques, and even the multi-factor RAFI methodology. And then there’s equal-weighting, an incredibly simplistic approach to indexing that has steadily gained traction in recent years thanks in no small part to some rather impressive performances.
The most popular equal-weighted fund is the Rydex S&P Equal Weight ETF (RSP), which includes all 500 components of the well-known S&P 500 in equivalent allocations. So RSP has all the same components of the ultra-popular SPY, but gives the same allocation to the largest and smallest companies in that benchmark. The result is a more even portfolio; whereas SPY is a top-heavy portfolio, RSP is very balanced. And there is an argument to be made that equal-weighting will avoid some potentially serious pitfalls of the cap-weighting methodology–specifically the tendency to overweight overvalued stocks and underweight undervalued ones. Upon rebalancing, RSP effectively shifts assets from the stocks with highest momentum (the best performers over the last quarter) to the recent laggards (those that performed poorly during the last three months). That disciplined rebalancing technique may have the effect of avoiding increased exposure to sectors where bubbles are forming, as well as allow investors to participate in rallies in sectors that receive only minor allocations in cap-weighted ETFs [Six Reasons To Consider Dumping SPY].
RSP Keeps Cruising
|RSP vs. SPY|
The distinction between RSP and SPY might seem insignificant; the overlap between the portfolios is, after all, perfect. But a quick look at historical performance reveals that the weighting strategy used can have a huge impact on bottom line returns. And for well more than two years now, RSP has been channeling its inner Charlie Sheen: the equal-weighted ETF just keeps winning.
RSP added about 0.7% in the second quarter, while SPY was basically flat. That marked the tenth consecutive quarter of outperformance for the equal-weighted ETF over its cap-weighted competitor; the last time SPY edged RSP during a quarter was the fourth quarter of 2008 (RSP lost 26.3%, while SPY dropped just 21.6%). Since the beginning of 2009, an investment in RSP has returned a little more than 87%. SPY is up a healthy 53% during that same period, illustrating the significant gap that can arise as a result of seemingly minor differences in index construction methodology [Talking ETF Weighting Methodologies With Tony Davidow].
There are, of course, stretches of time that have seen better results come out of SPY. During 2008 both funds cratered as the economy collapsed, but SPY’s declines were considerably more moderate than those endured by the equal-weighted alternative. At some point in the future, SPY will in all likelihood claim another quarterly victory.
SPY effectively has a tilt towards mega cap stocks, while RSP’s structure allows for much greater weightings towards stocks that are closer to the mid cap end of the spectrum [see RSP vs. SPY head to head]. As such, SPY can generally be expected to hold up better in bear markets when investors flock towards the relative safety of large cap stocks. When markets are booming, however, smaller stocks may outperform their large cap peers; such an environment would create a drag on SPY relative to RSP [Who Else Wants A Better S&P 500 ETF?].
So it’s a case of two ETFs that are very similar in some ways (correlation between the two is nearly perfect), but with some differences that can lead to significant performance gaps over the long run. The last two-plus years have seen an impressive winning streak for RSP, as equal-weighting has thrived during the market recovery. For those long-term investors who achieve large cap U.S. equity exposure through SPY, the equal-weighted alternative from Rydex might be worth a closer look [For ETF Investors, The Details Matter].
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Disclosure: No positions at time of writing.