Equal-Weight ETFs May Demand More Respect

The funds are in a way the Rodney Dangerfield of the exchange-traded fund world. But the tide may turn.

The average stock has a message for investment advisors and self-directed investors: Give me more respect! 

With the stock market’s long, generally bullish phase now in question, a type of ETF that might identify with the late legendary comedian Rodney Dangerfield could play a vital role for advisors trying to differentiate their investment practice. Because when it comes to equal-weighted equity exchange-traded funds, they “don’t get no respect at all!” 

Funds that track the broad U.S. stock market and the 11 S&P 500 subsectors come in one of two typical forms. The more popular method historically has been where the holdings are weighted within the ETF’s portfolio based on the market capitalization of each stock (the stock’s price multiplied by total number of shares outstanding). So, the bigger a stock gets, the more weight it carries in that ETF. 

The other way is for the ETF’s managers to own the same amount of each stock in dollars and percent of portfolio. The ETF is then adjusted back to that “equal weighting” each time they rebalance or reconstitute the fund’s holdings. 

SPY Outperforms

During that time, the SPDR S&P 500 ETF Trust (SPY) has outperformed the Invesco S&P 500 Equal Weighted ETF (RSP) by a annualized margin of 11.77% to 9.84%. That explains in part why SPY has accumulated more than $29 billion in assets, along with its peers that have many billions more. RSP, on the other hand, has an asset base of $614 million.  

But prior to the past 10 years, equal-weighted ETFs were not only competitive with their cap-weighted rivals, but they also outperformed frequently. The more recent dominance of SPY and other cap-weighted funds is a direct result of the market’s love affair with technology stocks, particularly the “Magnificent Seven” mega-cap names. Those companies can drive an ETF like SPY, occupying weights of 3-5% or higher. But in one like RSP, they will get the same weighting of roughly 0.2%, because 100% of that ETF is spread across 500 stocks.  

But what happens when that narrow market leadership turns the other way? The math does too, and that likely favors equal-weighted ETFs. 

More Money in Cap-Weighted ETFs 

When we peer into the subsectors of the S&P 500 and review the past performance of the 11 sector SPDRs versus their equal-weight counterparts (via a series of ETFs managed by Invesco), the assets and performance tell a similar story, in most respects. In fact, the assets under management in each of those 11 sector SPDRs is anywhere from 16 to 263 times higher in dollar terms than the equal-weight funds.  

For instance, the Technology Select Sector SPDR ETF (XLK) is over $48 billion in assets, while Invesco S&P 500 Equal Weight Tech ETF (RSPT), whose ticker symbol ironically resembles Rodney Dangerfield’s favorite word, “respect,” has amassed $2.9 billion. Both funds own the same stocks. They just own them in quite different quantities. And XLK has outperformed RSPT over the past one-, three-, five-, and 10-year periods, and by comfortable margins. 

Similar results have occurred in most sectors, though Basic Materials and Industrials bucked that trend. Invesco Equal Weight Materials ETF (RSPM) is a $280 million fund that has gained 155% the past 10 years, beating its cap weighted equivalent by about 30% over that time. And Invesco S&P 500 Equal Weighted Industrials ETF (RSPN), whose ticker symbol sounds like sports TV network, is a $543 million ETF that has outperformed a cap weighted rival by about 34% over the past decade. 

Capitalization weighting has dominated asset flows and performance charts for so long, investors could be forgiven for forgetting that equal-weighted ETFs even exist. But for advisors who want to stay fully invested in equities or at least not “bail out” if the market continues to fall, this could be an ideal time in the market cycle to consider the equal weighted route. Clearly, it is a contrarian move, based on what has occurred over the past 10 years.