Equal-Weighted ETFs Best When Value Leads

Jesse Emspak Mon Apr 28, 5:49 PM ET

Equal-weighted indexes have outdone the traditional cap-weighted indexes slightly and fare better in markets where small-cap value is favored over large-cap growth.

That's the word from a white paper issued yesterday by Standard & Poor's, looking at equal-weighted indexes over the past five years.

According to the paper, through the end of 2007 the S&P 500 Equal Weight Index's five-year return was 15.9%. The traditional S&P 500 returned 12.8%.

Over three years, the difference is less marked: 8.3% for equal weighted vs. 8.6% for the cap-weighted index.

The paper says the average outperformance for the S&P 500 EWI is 1.5% each year.

Choosing Drivers

Srikant Dash, head of global research and design at Standard & Poor's, says the reason equal-weighting does slightly better is that the stocks aren't picked with an eye toward what would drive them.

That is, there is no bias to capitalization, dividends, profits or other methods active managers use to pick stocks. "Nobody can always pick the right set of factors," he said.

Equal-weight indexing is exactly what it sounds like. Every stock in the index is weighted the same. Traditional indexes are weighted by market capitalization.

Proponents say equal weighting avoids some of the problems of cap weighting, such as putting too much emphasis on fad stocks.

In 1999, for example, technology companies were 29.2% of the index. That dropped to 14.3% in 2002.

Cap weighting made the decline in the index worse when tech stocks crashed.

In an equal-weighted index, a boom in one area won't lift the index as much, but a bust won't drag it down as far.

Better In Worse Markets

David Blitzer, chairman of Standard & Poor's index committee, says cap-weighted indexes work better in markets favoring large-cap or growth stocks.

He notes that from 1995 to 1999, traditional S&P weightings would have worked well.

But in the bear market that followed, small-cap and value stocks were more popular. That drove up their prices.

Small-cap stocks, being weighted equally, can help an equal-weighted index more than a cap-weighted index. So from 2002 to 2006, the equal-weighted index did better than the cap-weighted one.

Other firms have issued equal-weighted ETFs since Rydex rolled out its S&P Equal Weight ETF (AMEX:RSP - News).

XShares launched a set of REIT ETFs late last year. First Trust Nasdaq 100 Equal Weight Index ETF (NasdaqGM:QQEW - News) was launched in 2006.

Rydex has several equal-weighted ETFs. Tim Meyer, Rydex's ETF business manager, says the firm is looking at others but hasn't registered anything yet.