Small Cap Tilts With Equal Weight ETFs

July 24, 2014

Using equal-weighted ETFs can help put a small-cap and value tilt on a portfolio.

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article features Clayton Fresk, CFA, portfolio management analyst at Georgia-based Stadion Money Management.

Rick Ferri recently posted an article regarding portfolio tilting and the usage of small-cap and value ETFs. He described a process involving starting an allocation with total market-cap exposure and adding a slice of small-cap value stocks.

For advisors who have existing portfolios allocated toward a mix of different assets classes that may not easily afford switching to an allocation as Ferri described, an alternative way to capture the small/value tilt is through using equal-weighted as opposed to market-cap-weighted ETFs in various asset classes.

I’ll look at a variety of the different equal-weighted ETFs available and how substituting them into an existing portfolio may positively alter the risk/return profile of a portfolio.

Equal-Weight ETFs

The number of equal-weight ETFs and asset classes covered has increased over the past few years. Here is a list of equal-weight ETFs available:

Ticker Fund AUM ($M) Exp Ratio
Large Cap RSP US Guggenheim EW S&P 500 8372.2 0.40%
EWRI US Guggenheim EW Russell 1000 115.5 0.40%
Mid Cap EWRM US Guggenheim EW Russell Midcap 138.3 0.41%
Small Cap EWRS US Guggenheim EW Russell 2000 40.6 0.41%
Nasdaq QQEW US First Trust EW Nasdaq 100 428.2 0.60%
QQQE US Direxion EW Nasdaq 100 14.6 0.35%
EM EWEM US Guggenheim EW MSCI Emerging Markets 14.4 0.60%
Sector RCD US Guggenheim EW S&P Consumer Discretionary 88.9 0.50%
RHS US Guggenheim EW S&P Consumer Staples 160.4 0.50%
RYE US Guggenheim EW S&P Energy 308.1 0.50%
RYF US Guggenheim EW S&P Financials 100.8 0.50%
RYH US Guggenheim EW S&P Healthcare 224.4 0.50%
RGI US Guggenheim EW S&P Industrials 103.8 0.50%
RTM US Guggenheim EW S&P Materials 90.1 0.50%
RYT US Guggenheim EW S&P Technology 579.8 0.50%
RYU US Guggenheim EW S&P Utility 120.1 0.50%
MLP MLPN US Credit Suisse EW MLP 926.6 0.85%

A few other equal-weight ETFs of note, particularly in the large-cap space:

Also, the equal-weighted Russell 1000, midcap and 2000 ETFs named above have two layers of equal weighting. First, each sector is equally weighted, and then within the sector, each individual stock is equally weighted.

 

Exposure Differences

By taking out the cap-weighting aspect, the equal-weighted ETFs will naturally have smaller-cap skews.

As noted, this is one mechanism an advisor can use to gain a smaller-cap tilt without altering an existing asset class allocation. The degree of the tilt can vary depending on the market-cap segment. I will focus on the large-, mid- and small-cap names from above.

Style Analysis
Market Cap Large Mid Small Growth Value
Equal Weight S&P 500 37.50 96.4 3.6 - 31.3 68.7
Market Cap S&P 500 128.30 99.5 0.5 - 52.2 47.8
Equal Weight Russell 1000 22.99 72.9 26.8 37.1 62.9
Market Cap Russell 1000 113.37 94.8 5.0 52.7 47.3
Equal Weight Russell Midcap 8.60 66.2 33.4 - 45.3 54.7
Market Cap Russell Midcap 11.98 86.5 16.2 - 49.5 50.5
Equal Weight Russell 2000 1.12 - 16.8 82.8 45.0 55.0
Market Cap Russell 2000 1.74 - 38.2 61.7 50.2 49.8

Because the range of market caps defining the large-cap universe is much broader than that of mid- and small-cap universe, equal weighting in large-caps will have a more dramatic effect. Stated differently, the difference in size between the largest and smallest large-cap name will be much wider than the difference in size between the largest and smallest small-cap name.

This effect can be seen in both the market-cap differential as well as the style analysis. Focusing on the equal- versus cap-weighted Russell 1000 from above, the market-cap difference is nearly $90 million. The equal weight also has a larger skew toward the midcap exposure than the market-cap-weighted.

Looking at the style analysis, the equal weight has a nearly two-thirds value and one-third growth split versus the market-cap-weighted—nearly 50/50.

 

Portfolio Effect

To analyze the effect using equal-weight ETFs may have on a portfolio, I will use the following hypothetical portfolios:

Index (Bloomberg Ticker) Portfolio A Portfolio B
Market Cap Large 1 SPXT 25 20
Equal Weight Large 1 SPXEWTR 0 5
Market Cap Large 2 RU10INTR 25 20
Equal Weight Large 2 RU1ELCTR 0 5
Market Cap Mid RUMCINTR 15 10
Equal Weight Mid RUMEMCTR 0 5
Market Cap Small RU20INTR 15 15
Market Cap EM NDUEEGF 10 5
Equal Weight EM M1EFEWGT 0 5
Market Cap MLP AMZX 10 5
Equal Weight MLP MLPXTR 0 5

Because many of the ETFs were brought to market at the end of 2010, I’ll use the appropriate index’s monthly total return—net of the fund expense ratio—to get a longer-dated analysis. Because of a lack of historical data, I’ll only use the market-weighted small-cap exposure in this analysis.

The results are as follows:

 

Comparative_Portfolio_Returns

 

Portfolio A Portfolio B
Return 7.5% 8.5%
St Dev 15.9% 16.1%
Sharpe 0.35 0.40
Max DD -50.9% -50.8%
Avg DD -9.6% -8.6%
Exp Ratio 0.27% 0.30%

The addition of the equal-weighted exposure added nearly a 1 percentage point return per year with only moderately higher risk. Additionally, while the max drawdown for both portfolios was the same, the average drawdown for Portfolio B was nearly 1 percentage point better, meaning the portfolio recovered from its drawdown more rapidly.

Implementation

One aspect the analysis above ignores is the implementation of the strategy via ETFs—notably costs, tracking error, etc.

Currently, some of the equal-weighted ETFs mentioned are rather small and have low trading volumes. However, the liquidity of the underlying holdings looks to be much better than the ETF itself. For example, the 30-day average volume on EWRS is currently 5,700 shares.

However, the implied liquidity is nearly 267,000 shares. So, if one is looking to add these names into a portfolio, particularly in larger size, it may be important to consult an authorized participant to find the best way to implement the desired trade.

Conclusion

As Rick Ferri described in his article, the addition of small-cap and value stocks can have a positive benefit to a portfolio. After analyzing the use of equal-weighted ETFs, the addition of this exposure into an existing cap-weighted allocation could also provide positive risk/return benefits.


At the time this article was published, the author's firm held positions in RSP, QQEW and QQQE on behalf of clients.

Founded in 1993, Stadion Money Management is a privately owned money management firm based near Athens, Ga. Via its unique approach and suite of nontraditional strategies with a defensive bias, Stadion seeks to help investors—through advisors or retirement plans—protect and grow their “serious money.” Contact Stadion at 800-222-636 or www.stadionmoney.com. References to specific securities or market indexes are not intended as specific investment advice.

 

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