An equal-weighted ETF allows for a more comprehensive exposure to an index and US corporations than achieved from restrictive “weighted” alternatives.

— Yiannis Mostrous, Global ETF Profits

In my weekly perusal of SEC Form 485 filings (mutual fund prospectuses), I came across a May 9^th filing of Rydex SGI, a Maryland-based investment firm that specializes in leveraged, currency, and equal-weighted mutual funds and ETFs. The May 9^th filing involved the introduction of two new equal-weighted index ETFs: (1) S&P MidCap 400; and (2) S&P SmallCap 600.

These two new ETFs will be in addition to the 16 equal-weighted index ETFs the fund firm already offers. Reading the prospectus got me thinking about equal-weighted index ETFs generally. Why would one prefer them to regular index ETFs?

As I wrote last August in Mechanical Investing and Fundamental Indexing, regular index funds are market-cap-weighted, which over-weights stocks that are larger as measured by their market capitalization (i.e., number of shares outstanding times price per share). In contrast, equal-weighted index funds weight each stock in the index equally, regardless of their relative market capitalizations. Let’s compare a regular iShares S&P 500 index ETF (NYSE: IVV) with the Rydex S&P 500 Equal-Weight ETF (NYSE: RSP):

Source: Morningstar

Equal-weighted RSP aims for a 0.20% weighting per stock (1/500). So why is National Semiconductor currently overweight at 0.33%? Because RSP only rebalances quarterly. Stocks that rise in price between rebalancings will temporarily become overweight. During this quarter, National Semi was acquired by Texas Instruments at a huge 77% premium, which explains why National Semiconductor has become overweight. This overweighting will be eliminated at the next rebalancing when the fund sells off 0.13% of National Semi and uses the cash to buy other stocks in the S&P 500 that dropped below a 0.20% weighting during the past quarter.

Pros and Cons of Equal-Weighted ETFs

I see the following advantages for equal-weighted ETFs:

• Avoids buying stocks as they get more expensive and overvalued
• More diversified equity exposure
• Greater exposure to small and mid-cap stocks, which have higher growth potential

And some disadvantages for equal-weighted ETFs:

• Rebalancing means higher turnover and additional transaction costs
• Not tax efficient
• Higher expense ratio
• Buys more lower-cap stocks that might be lower-cap for a reason (i.e., losers)
• Lower dividend yield
• Lower earnings and cash-flow growth

Equal Weighted Has Outperformed Market-Cap Weighted

Which ETF is better? Based on past performance, there is no contest: advantage RSP. Since RSP’s introduction eight years ago in April 2003, it has outperformed IVV by more than 52.4% total, or 3.6 percentage points per year:

Source: Bloomberg

The question is whether past performance is predictive of future results. RSP’s outperformance is based on the fact that small and mid-cap stocks have outperformed large-cap stocks over the past decade. Some analysts believe that large-cap stocks will outperform in the next decade. If so, I wouldn’t count IVV out.

Invest in Index ETFs with the Help of Global ETF Profits

Global ETF Profits co-editors Ben Shepherd and Yiannis Mostrous focus on low-cost ETFs and ETNs that are most likely to outperform the overall market – both equity and fixed income — going forward. They are not “index huggers” but try to beat the market with their contrarian take on the best industry sectors. In fact, Ben and Yiannis have identified 25 ETFs in a multitude of different sectors that are in buy range right now.

In fact, one of their favorite index ETFs right now is of the equal-weight variety. To find out which one and the specific names of all of Ben and Yiannis’ favorite index ETFs, consider giving Global ETF Profits a try today!