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 Scott Kubie, chief strategist of Omaha, Nebraska-based CLS Investments.
Large-cap stocks offer the best valuations in the U.S. stock market, but those valuations become significantly more attractive when using equal-weighted ETFs instead of cap-weighted ETFs.
Examining the P/E calculation Morningstar uses in its style box calculation,i equal-weighted, large-cap stocks offer cheaper valuations than cap-weighted benchmarks at all levels of capitalization. The low relative valuations are rare and lead me to favor large-cap, equal-weighted securities in allocations.
Three ETFs stand out in this space.
The most liquid with the most historical information is the Guggenheim S&P 500 Equal Weight ETF (RSP | A-79). It is by far the largest, with nearly $10 billion in assets. As its name implies, it allocates an equal portion to each stock in the S&P, which comes out to 0.2%. While those weights vary between rebalances, no position dominates the portfolio.
Two other equal-weighted ETFs also offer attractive exposures at higher capitalizations. Guggenheim just launched its S&P 100 Equal Weight ETF (OEW) on June 30. The S&P 100 is a subset of the S&P 500 that emphasizes the largest companies in the S&P 500.ii The PowerShares Russell Top 200 Equal Weight Portfolio (EQWL | B-87) provides similar exposure, but adds another 100 very large domestic companies. This ETF has 10 years of history and more than $30 million in assets.
Valuations Across Capitalization
How much cheaper are equal-weighted large-caps than cap-weighted indexes? Because it has the longest history, RSP is used for comparisons. The first comparison ranks RSP against cap-weighted ETFs tracking the iShares S&P 100 (OEF | A-96), the iShares Core S&P 500 ETF (IVV | A-97), the iShares Core S&P Midcap (IJH | A-82) and the iShares Core S&P Small Cap ETF (IJR | A-92).
The chart below shows RSP has the lowest valuation of the five ETFs. This is particularly rare. In the last 10 years, it has only happened 13 times. Nine of these occasions occurred over a 10-month period starting in late 2008. One occurred in early 2014. The only other time RSP has been this cheap is over the last three months.
Large-Caps Only
While comparing RSP across multiple capitalizations provides value, CLS tracks RSP to adjust its large-cap domestic allocation. How does RSP perform when it is cheaper than the S&P 500?
Using semiannual data dating back to 2003 (see table), we can see RSP outperforms consistently in periods when it is cheaper than the underlying index. RSP has only lagged IVV for one six-month period when it was cheaper than IVV at the beginning of the period. This compares to eight six-month periods where it was cheaper and outperformed.
| Number of Occurrences | Lower P/E | Higher P/E |
| Outperforms | 8 | 10 |
| Underperforms | 1 | 6 |
When RSP is more expensive than IVV, it tends to outperform, but not as consistently. There were 17 six-month periods when RSP carried higher valuations. It outperformed in 10 and lagged in six. Those odds strike me as attractive.
Can RSP Replace IVV?
RSP carries more risk than IVV, and that likely contributes to its outperformance. Even though the stock allocations are significantly different between an equal-weighted and cap-weighted benchmark, the sector distributions shown in the chart below are similar.
RSP can replace IVV, but keep in mind that risk levels are likely to be higher. Because OEW and EQWL invest in just the largest companies in RSP, I expect they will be slightly less volatile than RSP.
For a larger view, please click on the image above.
i Price/projected earnings for a stock is the ratio of the company's most recent month-end share price to the company's estimated earnings per share (EPS) for the current fiscal year. (Morningstar)
ii http://us.spindices.com/indices/equity/sp-100/
At the time of this writing, CLS Investments invests in RSP, OEF, IVV and IJH for its clients. CLS Investments is a third-party investment manager and ETF strategist. It began to emphasize ETFs in individual investor portfolios in 2002, and is now one of the largest active money managers using exchange-traded funds. Contact CLS' Chief Strategist Scott Kubie at 402-896-7406 or at [email protected]. Please click here for a complete list of relevant disclosures and definitions.
