Is It Time For an Equal Weight ETF? - ETF News And Commentary

Financial markets today are marked with uncertainties arising on account of weak economic conditions around the globe. Thanks to the slowdown in most emerging as well as developed markets, a sustainable recovery seems to be a still distant phenomenon.

The present investment scenario demands continuous monitoring of portfolios and positions. In order to do this, many investment managers and investors are putting more of a focus on asset allocation at this point of time.

Unlike range-bound, non-volatile market conditions, where a traditional ‘buy and hold’ strategy would be the call of the day for most investors for a decent upside, the present volatile markets demands an investment strategy that reduces the overall portfolio volatility (see Three Defensive ETFs for a Bear Market).

While this can be done in a number of ways (like placing bets on defensive sectors like healthcare and consumer staples), an ETF approach is probably the most efficient and cost effective avenue to achieve the aforementioned objective.

Investors could look into a number of low volatility products such as the Russell 1000 Low Volatility ETF (LVOL) or PowerShares S&P 500 Low Volatility Portfolio (SPLV) which seeks to minimize the overall volatility by holding stocks that show little variations in price and returns.

The current market turbulences might be a good buying opportunity for these low volatility funds as these products would go a long way in reducing overall portfolio beta for an investor (read Four Easy Ways to Play Beta and Volatility with ETFs).

LVOL and SPLV are up 7.2% and 7.8%, respectively, on a year-to-date basis. From a risk point of view, LVOL has an annualized volatility of just 20.33% and a beta (against the S&P 500) value of 0.76, whereas the annualized volatility for SPLV stands at 16.05% and a beta value of 0.65. Therefore we see that reducing overall volatility might go a long way in maximizing total returns in times of volatile markets.

Yet while these low volatility products are certainly one way to tackle the market, some who are willing to take on a little more risk but still want extreme diversification, could look to equal weight ETFs instead. These funds break the link between market cap and stock weight in a fund, and could be overlooked ways to play the market at this time, beyond the low volatility space (see more in the Zacks ETF Center).

Weighting Methodologies in Focus

While some investors may not know it, a significant factor which determines the performance of a particular fund is the index weighting methodology. The conventional “float adjusted market capitalization weighting methodology” seems to be extremely popular despite some of the flaws in the technique.

After all, market cap weighted funds tend to have a significant bias to large cap stocks and indeed, a few choice mega caps in particular. Furthermore, these funds, by nature, do not offer much in terms of small and mid cap exposure suggesting other ways could be the way to play the market.

This could be especially true in the case of Equal Weight ETFs, as these funds not only go a long way in reducing overall risk, but also provides significant upside potential, mainly thanks to their equal allocation towards the entire spectrum of market capitalization levels (see Alternative ETF Weighting Methodologies 101)..

The best thing about this approach is that performance is not heavily dependent on the returns in a particular stock or group of securities. Furthermore, with quarterly rebalancing, equally-weighted funds tend to take cash in on the overvalued segments and reinvest in the underperforming ones, potentially allowing for outperformance if trends reverse.

However, investors should note that there are some downsides to the structure. If trends in sectors continue over multiple quarters the equal-weight funds could be laggards, while a similar situation could arise in declining and risk off markets.

Yet for investors looking for a new way to play this uncertain market, and one that can still gain if events turn around in the global economy, these equal weight ETFs could be interesting picks. For these investors, we have highlighted two of the more popular, and well-known, options in the space for those of you considering a first step into the equal weight ETF world:

Guggenheim S&P 500 Equal Weight ETF (RSP)

Launched in April of 2003, RSP places its bets equally on the stocks of the S&P 500 index without regard to their market capitalization or any other fundamental/technical factor. It tracks the S&P Equal Weight Index putting roughly 0.2% in each stock.

Although the index is itself a subset of the S&P 500 index which tracks the performance of 500 of the largest companies in the U.S equity markets, the equal weighting methodology causes the total returns of RSP to substantially vary from the actual S&P 500 total returns (read Five Best Performing ETFs (So Far) in 2012).

The ETF charges 40 basis points in fees and expenses and has managed to amass $2.74 billion in total assets. This suggests that it is a relatively popular fund and that bid ask spreads should be extremely tight overall.

Investors should note that the fund will likely outperform in bull markets, thanks to small caps surging in times of ‘risk on’ trading. However, the opposite is also true in bear markets; products like SPY will outperform their equal-weight counterparts in times of declining prices.

RSP has fetched 11.3% in terms of returns on a year-to-date basis, slightly lower than SPY over the same time frame. Furthermore, the dividend is somewhat light due to higher small cap holdings—coming in at 1.49%-- while the average volume is at roughly 610,000 shares on an average day.

Fortunately, long term charts do favor RSP, as the fund has crushed SPY in the past five year period, adding about 6.3% compared to a 1.2% loss for the market cap weighted version

ALPS Equal Sector Weight ETF (EQL)

The ETF places its bets equally across the nine broad sectors that comprise the S&P 500 index. This implies that EQL has roughly 11.11% exposure towards each sector. This strategy goes a long way in reducing the overall risk of the ETF, since equal allocations are given to volatile sectors like Technology and Financials and defensive sectors like Consumer Staples or Healthcare.

From its basic structure, EQL qualifies to be an ETF of ETFs, as it gains exposure across all sectors by investing equally in the nine select sector ETFs of the SPDR fund family managed by State Street Global Advisors.

The strategy has produced an ETF that has $72.14 million in total assets and decent, but not great volume on a daily basis. The ETF was launched in July 2009 and tracks the Bank of America Securities-Merrill Lynch Equal Sector Weight Index.

Investors should note that the product is relatively pricey as it comes in with a 52 basis point expense ratio. This is largely due to the fund having two types of fees; the general management fee and then the carry-over ETF fees from the underlying holdings (read Guide to the 25 Cheapest ETFs). Despite this fact, the ETF could make for a great choice for investors with a long term view willing to place their bets on overall U.S equity performance.

The ETF has returned 10.4% so far this year and has an average daily volume of 13,840 shares. This puts it below its counterparts, but the fund could have lower volatility levels than these as well. After all, this fund puts far more in utilities and much less in tech than SPY, suggesting a lower beta for this product overall.

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ALPS-EQL SEC WT (EQL): ETF Research Reports

RUSL-1K LO VOLA (LVOL): ETF Research Reports

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

POWERSH-SP5 LVP (SPLV): ETF Research Reports

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

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