Is The Reign Of Equal Weight ETFs Over?

As the U.S. stock market got stuck in a web of uncertainty with China being the major culprit, the often overlooked equal weight ETFs grabbed attention over the past month and easily crushed their market counterparts. But will this trend continue?

Specifics behind Equal Weight ETFs

These funds do a great job in managing single-security risk thanks to their equal allocation in the entire spectrum of market capitalization levels regardless of size. As a result, it limits the risk of a severe downfall in any particular security, providing a nice balance in the portfolio. Additionally, with quarterly rebalancing, equal weighted funds tend to cash in on the overvalued segments and reinvest in the underperforming ones, potentially allowing for outperformance if the trends reverse.

While these have a minimal concentration risk, they charge a hefty expense ratio compared to the fundamentally/capitalization weighted counterpart (read: A Guide to 10 Cheapest ETFs).

Below, we have compared the equal weight funds with their market cap counterparts in terms of their risk-return profiles, expenses, as well as popularity:

The above table reveals that while equal weight ETFs have performed better than the market cap counterparts over the last one-month period; they have lagged from a six-month look. Additionally, these funds carry a little higher risk, and are relatively less popular and liquid ensuring a wide bid/ask spread. This increased the total cost of trading further beyond the high expense ratio.

More specifically, RSP outperformed by 81 bps in the past one–month period mainly due to the global market sell-off that pushed down stocks in every corner. Since RSP allocates very less to a single security, it is less impacted by the malaise. On the other hand, SPY allocates higher to the heavyweights that have seen their share prices tumbling the most. It is the same for the other two market cap ETFs – IWR and IWM (see: all the Large Cap ETFs here).  

What Lies Ahead?

It seems that the recent supremacy of the equal weight ETFs will soon disappear when the stock market recovers. This is because the latest slew of U.S. economic data points to a stronger-than-expected economy that would drive the stocks higher. And when the market starts booming, the stocks that have underperformed will gain more leading to higher prices for the market-cap ETFs.

As cap-weighted funds are often said to lean toward a growth style, weighting and stock price are directly related, and thus price momentum is a growth characteristic. Further, investors love to invest in the products having a superior asset base, high daily volumes, tight bid-ask spreads and lower expense ratios that make market-cap ETFs more attractive than the equal weighted ones.

At times, both categories deliver almost similar returns, so investors might not want to pay more for investing in the same group of companies. Moreover, an equal weighted portfolio pays a lower dividend as these have lower allocation to the highest paying dividend stocks (read: 5 Overlooked Dividend ETFs Worth Buying Now).

However, if uncertainty in China and Fed policy continue to play foul in the stock market, the equal weight ETFs might stay in control in the coming days. Notably, equal-weighted funds tend to exhibit a value tilt.