Many individual investors and financial advisers consider equal-weighted index funds to be a sure-fire way of beating the stock market.
They’re wrong. In fact, equal-weighted funds, which give the same percentage allocation to each of the stocks they own, are more likely to lag their capitalization-weighted peers — which weight each stock according to its market valuation — on a risk-adjusted basis over the long term.
But at least since the March 2009 U.S. market bottom, equal-weighted index funds have beaten the broad U.S. market. This recent outperformance is not surprising, according to Lawrence Tint, chairman of Quantal, a risk-management firm for institutional investors. In a recent interview, Tint pointed out that equal-weighted index funds are riskier than their cap-weighted counterparts, so they are expected to outperform when the market is rising. Just the opposite will be the case when the market heads south.
Take the cap-weighted and equal-weighted versions of the S&P 500 SPX, -0.11% , for example. Since the March 2009 U.S. market bottom, the ETF that represents the equal-weighted version of the S&P 500 (the Guggenheim S&P 500 Equal Weight ETF RSP, +0.12% ) has beaten the cap-weighted version (SPDR S&P 500 ETF Trust SPY, -0.12% ) by more than two percentage points per year on an annualized basis (according to FactSet)
In contrast, during the bear market from October 2007 to March 2009, the equal-weight S&P 500 ETF lagged the cap-weighted version by 3.6 annualized percentage points.
In fact, it’s not accurate to think of equal-weight index funds as benchmarked to the broad stock market, Tint added, since the stock market represents the combined holdings of all investors and is therefore, by definition, capitalization weighted. Equal-weighting represents a specific bet on certain sectors and investment styles, and in that regard an equal-weighted fund is not dissimilar to hundreds of other mutual funds and ETFs that also make specific bets.
As with any of those other funds and ETFs, you need to decide whether you want to make the bets inherent in an equal-weighted fund. The two most significant of these bets are:
· Small-cap over large-cap. Equal-weighted indices give more weight to small-cap stocks than do cap-weighted indices, and, accordingly, less weight to large-cap stocks. So equal-weighted index funds will tend to come out on top during periods in which small-caps outperform large-caps. They will lag when the opposite is the case.
· Contrarian over momentum. Cap-weighted funds are making momentum bets because their portfolio allocation to a stock automatically grows as it performs particularly well — and falls if the stock is a poor performer. Equal-weighted index funds make just the opposite bets, since they constantly are selling stocks that have performed well in order to buy more of stocks that have performed poorly.
So there is nothing magical about equal-weighted funds. An equal-weighted version of an index will outperform the cap-weighted version when small caps are beating large caps, or when contrarian approaches are beating momentum, or both. It will underperform when the opposite of those two conditions prevails.
One important additional factor to keep in mind about equal weighted index funds: expenses. These funds have greater transaction costs because of the frequent rebalancing needed to bring each stock’s allocation back to equal weighting. This involves selling portions of their outperforming stocks and buying more of their underperformers. No rebalancing transactions are required by a cap-weighted fund.
Transaction costs involve more than just brokerage commissions, Quantal’s Tint noted. Since equal-weighted index funds will be trying to buy and sell the same stocks at more or less the same time, they can be expected to receive more competition and higher market-trading impact on their trades than would otherwise be the case.
Moreover, these transaction costs are above and beyond the higher expense ratios that equal-weighted index funds often charge. The Guggenheim S&P 500 Equal-Weight ETF, for example, has an expense ratio of 0.39%, in contrast to 0.09% for the SPDR S&P 500 ETF. Even if equal-weighted index funds didn’t face the other hurdles mentioned before, these greater expenses and transaction costs alone represent a big long-term hurdle.
For more information, including descriptions of the Hulbert Sentiment Indices, go to The Hulbert Financial Digest or email mark@hulbertratings.com .