With more than 1,500 ETFs available on the market today, investors have grown comfortable with utilizing some of the more sophisticated strategies out there for fine tuning their exposure and tapping into previously difficult-to-reach asset classes. When it comes to tactical allocation, the sheer diversity among ETFs comes in handy; investors can pick and choose from an array of country, sector, asset class, and style-specific funds. Innovation in the ETF industry has in turn spawned a variety of alternative weighting methodologies, offering new ways to access traditional market capitalization-weighted indexes [see 101 ETF Lessons Every Financial Advisor Should Learn].
Watch Your Weighting Methodology
There is a great debate that rages when it comes to which weighting methodology is best. On the traditionalist side, market cap-weighting, in which the largest allocations are afforded to the largest companies, has remained by far the most popular option thanks to the low costs and low maintenance requirements associated with this approach. However, there are those who wish to stay away from the nuances associated with cap-weighted ETFs, including their tendency to be “top-heavy” in nature, meaning they allocate the majority of their assets to just a few of the biggest securities [see The Truth About Alternative Weighting Methodologies].
So which methodology works best? As you may have suspected, the answer isn’t straightforward; some strategies are more appropriate for others in certain scenarios. To further assist with answering this age old question, below we compare the annual returns of the biggest ETFs tracking each of the most prominent weighting methodologies available to ETF investors.
When all is said and done, each of the various alternative weighting methodologies out there boasts a different set of pros and cons depending on your individual goals and risks preferences. It’s important to take a look under the hood of each strategy to better understand why it might fare better or worse than others depending on the prevailing economic conditions at hand [see Head-To-Head ETF Comparison Tool].
Market Cap: SPDR S&P 500 (SPY, A)
This methodology is by far the most popular one out there. ETFs using this traditional weighting approach assign a weight to each various sub-component based on the total value of its equity; this results in allocating more to the biggest securities, and less to the smaller ones. In other words, this approach overweights the most dominant securities on the market; this is appealing to those who favor a momentum strategy, but may be less than ideal for those wary of valuations in a particular sector.
Equal Weighted: Guggenheim S&P Equal Weight ETF (RSP, B+)
This methodology holds an equal dollar amount of each of the various sub-components. This approach is generally more expensive to implement because it requires regular rebalancing, seeing as how changing stock prices affect the security’s individual weighting in the ETF portfolio. The result is equal allocations across securities of all sizes, meaning that small, mid, and large caps all get equal representation. This sort of approach has demonstrated the ability to deliver stellar gains when bullish forces are prevailing; notice how RSP crushed the competition at the start of the bull market in 2009 as investors piled back into the riskiest corner of the equity market as the clouds of uncertainty scattered [see Equal Weight ETFdb Portfolio].
Dividends Weighted: WisdomTree Large Cap Dividend Fund (DLN, A)
This methodology ignores market cap and security prices altogether; instead, it allocates weights to each security based on the cash dividends paid out. Simply put, the dividend weighted approach affords the largest weights to the companies who paid out the most dividends to shareholders. This sort of approach may be appealing to more conservative investors, judging by DLN’s ability to deliver fairly consistent returns over the last five years, even during 2011 when all other methodologies were largely flat. On the other hand, because DLN inherently cannot hold securities that don’t pay dividends, this ETF missed out on the impressive gains generated by growth stocks in 2009 and 2013 [see 101 High Yielding ETFs For Every Dividend Investor].
Earnings Weighted: WisdomTree Earnings 500 Fund (EPS, B+)
This methodology determines the weight afforded to each various sub-component based on its reported earnings. Simply put, companies that generate higher cumulative earnings account for a greater portion of the ETF’s total assets under management. While this strategy does avoid potentially risky growth companies that have negative earnings, it effectively results in a bias towards value stocks. This sort of bias is not necessarily a drawback, as some investors prefer the price stability that is often associated with the Large Cap Value Equities category.
Revenues Weighted: RevenueShares Large Cap Fund (RWL, B+)
This methodology goes beyond “bottom line” metrics like earnings and dividends when it comes to determining security allocations; as the name suggests, this approach weights each security based on its top-line revenues. As mentioned previously, whereas the dividend and earnings-weighted approaches may introduce a value bias, the revenue-weighted methodology strives to be more balanced by giving more weight to growth stocks that the other two strategies might otherwise entirely exclude. On the other hand, critics of this strategy point out that earnings and revenues are easily, and often, manipulated to meet shareholder expectations, whereas cash dividend payouts are hard to fake.
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Disclosure: No positions at time of writing.