The Case For The Equal Weighted ETF ‘EQAL’

March 13, 2015

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 is by Clayton Fresk, CFA, portfolio management analyst at Georgia-based Stadion Money Management.

(Editor's note: An earlier version of this story incorrectly stated that "EQAL" is rebalanced monthly. It is rebalanced quarterly. We corrected the information and regret the error). 

There has been a lot of press recently regarding the proliferation of “smart beta” ETFs. These ETFs use various methodologies to try to gain an advantage (or at least a perceived advantage) from their traditionally weighted counterparts.

These methodologies can become very complex, but one that’s rather simple is equal weighting. In this piece, I’ll discuss a few aspects of equal-weighted indexes I favor, and then touch on why I like the PowerShares Russell 1000 Equal Weight Portfolio (EQAL) in particular.

Market Breadth

Market breadth is an input I find vitally important in a market analysis. While looking at price action is obviously important, I feel delving into market internals is an equally important measure to determine the health of the market. An example measure is the advance/decline ratio.

Here’s an example (albeit rather extreme) of a situation in which price and breadth measure could give conflicting signals. Let’s say the top 25 tickers in the S&P 500 (which represents about 30 percent of the weighting) are all up for a combined 2.5 percent. At the same time, let’s say that the remaining ~475 tickers (which represent approximately 70 percent of the exposure) are all down for a combined 1 percent.

Because of the market-cap-weighted structure, the index as a whole would have eked out a gain of about 5 basis points. This would be the headline number an investor would see on the nightly recap. However, looking at the internals, having 475 out of 500 tickers being lower on the day would be a rather glaring negative signal.

Using an equally weighted index would give a price signal better reflective of the market internals. In the above example, the top 25 tickers would represent only 5 percent of an equally weighted index, with the other tickers contributing 95 percent. This equates to a negative 83-basis-point return versus the plus-5-basis-point return on a market-cap-weighted index.

Smaller Cap & Value Skew

When small-cap stocks are outperforming large-caps, I view this as a positive reflection on market health, as investors are speculating on the performance potential of smaller-cap stocks rather than flocking into the flight-to-quality trade into larger-cap names. Additionally, research clearly indicates the benefits of tilting toward value (and smaller-cap) stocks.

Here is an analysis of the market-cap and style exposures for the S&P 500 and Russell 1000 indexes, both on a market-cap and equal-weight basis.

  Market Cap Large Smid Growth Value
Market Cap S&P 500 138.3 99.5 0.5 52 48
Market Cap Russell 1000 122.7 95.7 4.3 53 47
Equal Weight S&P 500 38.6 95.7 4.3 31 69
Equal Weight Russell 1000 23.3 72.2 27.8 37 63

 

Sector Equal Weight

One reason I favor using the equal-weight Russell products is the additional layer of differential that comes from equal weighting the sectors, and then equal weighting the equity names.

Below are views on the sector exposure in both the market-cap and equal-weighted S&P 500 and Russell 1000, one using the Russell sector methodology (RICS) and the other using the GICS methodology.

 

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