Are Equal Weight ETFs Worth The Cost? - ETF News And Commentary

Most of the broad based equity indexes are making higher highs and the S&P 500 is well on its way towards its all time high mark. However, it is still very difficult to gauge the residual life in this generally bullish environment. As we have seen in the recent past the markets have silenced many who were skeptic about the legs in this uptrend.

Having said this it is also important for investors to appreciate that a correction just might be long overdue, especially with recent events out of Europe. This demands special consideration for broad based ETF investors as they will be most susceptible to a plunge in the equity indexes (see Time to Buy Energy ETFs?).

In this regard it is worthwhile to note that the degree of the index movement depends heavily on its weighting methodology.

For example, a market capitalization weighted index will be more vulnerable to a fall in companies with higher market capitalizations than companies with a higher fundamental weight such as revenue or earnings.

However, the case will be exactly opposite in case of a revenue weighted index. And in all probability the companies with higher market capitalization weights may not be the same as companies with the highest revenue weights (read Has the Italy ETF Hit Bottom?).

In any case, there can be no hard and fast rule to judge which is the best weighting methodology primarily because it depends on the market scenario. However, there is a certain class of ETFs, Equal weight ETFs, which seek to nullify the effect of many weighting methodology biases, and offer up a more holistic approach to asset weighting.

Needles to say these ETFs will have almost zero concentration risk as the components are allocated almost equal weighting. However, while minimizing this concentration risk these ETFs charge a hefty expense ratio. This is especially true considering the expense ratios of their fundamentally/capitalization weighted counterpart (see As Yen Weakens, Currency Hedged ETFs Soar).

With this backdrop the biggest question is whether the high expense ratios of the equally weighted ETFs are justified by bigger performance returns? The table and chart below seek to find the answer.

 

Data Points	Large Cap		Mid Cap		Small Cap
	Regular Wtd.	Equal Wtd.	Regular Wtd.	Equal Wtd.	Regular Wtd.	Equal Wtd.
ETF	SPY	RSP	IWR	EWRM	IWM	EWRS
Return (1 year as of 13th March 2013)	15.66%	18.12%	17.68%	17.22%	17.20%	13.23%
Risk (measures as 3 year annualized standard deviation)	18.00%	20.12%	20.50%	20.84%	24.66%	24.66%
Expense Ratio	0.09%	0.40%	0.21%	0.42%	0.25%	0.44%
Total Assets (million)	$133.08 billion	$4.2 billion	$7.63 billion	$58.74 million	$19.99 billion	$14.37 million

The table above compares the capitalization weighted broad market ETFs with their equal weighted counterparts in terms of their risk-return profiles, expenses, as well as popularity.

An analysis of the above table reveals that there is very little to choose from the ETFs in case of their risk return profiles. In fact, the equal weighted ETFs which were ‘perceived’ to be less risky, actually turn out to have a higher realized volatility over the course of the past 3 years than their capitalization weighted cousins (although the differences are quite paltry and are largely due to a greater weighting to small caps) (see Three Most Popular ETFs of February).

However, the only noteworthy differences seem to be in the expense and popularity section.

As we can see, from the large cap space the Guggenheim S&P 500 Equal Weight ETF (RSP) charges an expense ratio which is more than 3 times that of the SPDR S&P 500 ETF (SPY). However, we also do see RSP outperforming SPY over the course of the last one year.

One of the biggest reasons for this was the Apple Inc. effect which has slumped pretty badly over the year despite strength in the broad market. This impacted SPY more than RSP as the tech giant once accounted for almost 4.5% of its portfolio.

Also, from the mid and small cap space the expense ratio for Guggenheim Russell MidCap Equal Weight ETF (EWRM) and Guggenheim Russell 2000 Equal Weight ETF (EWRS) is almost double that of the iShares Russell Midcap ETF (IWR) and the iShares Russell 2000 ETF (IWM). This is despite the fact that there doesn’t seem to be much of a difference on the risk-return tradeoff front.

Bottom Line

Although the equal weight ETFs charge a hefty premium in terms of fees and expenses, they often do not differ by much in terms of many metrics, besides the holdings weights. A slightly longer term performance picture (2 years) also states the same fact (see more in the Zacks ETF Rank Guide).

As we can see from the above chart, there is very little difference between the capitalization weighted and the equal weighted ETFs. However, a superior asset base, high daily volumes, tight bid-ask spreads and substantially lower expense ratios make investments in the traditional capitalization weighted ETFs far more attractive than the equal weighted ones.

Still, one can certainly argue that in times when lower market capitalization levels are leading the way, these equal weight products could be the place to be. Beyond that though, many investors may want to look for cheaper options in the space, as performances can be relatively similar, at least over long time periods.

Want the latest recommendations from Zacks Investment Research? Today, you can download 7 Best Stocks for the Next 30 Days. Click to get this free report >>

GUGG-R MC EW (EWRM): ETF Research Reports

GUGG-R 2K EW (EWRS): ETF Research Reports

ISHARES TR-2000 (IWM): ETF Research Reports

ISHARS-RS M IDX (IWR): ETF Research Reports

GUGG-SP5 EQ ETF (RSP): ETF Research Reports

SPDR-SP 500 TR (SPY): ETF Research Reports

To read this article on Zacks.com click here.

Zacks Investment Research

Want the latest recommendations from Zacks Investment Research? Today, you can download 7 Best Stocks for the Next 30 Days. Click to get this free report