When constructing a growth or income portfolio, I always start with core positions that build the foundation for a diversified and balanced strategy.
Core positions typically track established indices such as the S&P 500 or Dow Jones Industrial Average because they give you diversified correlation to the broader market. Then you can layer in some sector, industry or special-situation funds to enhance the characteristics of your portfolio, given the amount of risk you are willing to take.
Another way to juice the returns of your portfolio is to look for core positions that are outperforming their peers. And that’s exactly what equal-weight ETFs have been doing for some time now.
ETFs that follow a market cap-weighted index allocate the majority of their assets to the largest stocks in their portfolio. The largest stocks will therefore have an outsized pull on the performance of the ETF over time because of their higher concentration. These market cap weightings are typically rebalanced on a quarterly basis based on the size of the stocks in the index at the end of the quarter. For example, Apple (AAPL) is the largest holding in the SPDR S&P 500 ETF (SPY) with 2.8% of the total assets, while AutoNation (AN) at just 0.01%.
By contrast, equal-weight ETFs allocate their portfolios equally across every stock in the index no matter what their fundamental characteristics may be. The Guggenheim S&P 500 Equal Weight ETF (RSP) has the same number of stocks as SPY, but every stock in the ETF has a weighting between 0.15% and 0.25%. The fund is rebalanced quarterly to adjust for stocks that underperform or outperform to bring each allocation back into equal balance.
It might seem like the differences between these two strategies are minor, but the disparity in performance returns have been quite significant over time.
If you look at the one-year chart of SPY vs. RSP below, you will see that the equal-weight fund has outperformed its peer by more than 7%. That is a noteworthy difference in total return in just 52 weeks.
Another stark example of equal-weight outperformance over the past year has been the difference between the PowerShares QQQ (QQQ) and the First Trust NASDAQ-100 Equal Weight Index Fund (QQEW). QQEW has outperformed QQQ by nearly 12% over the past 12 months.
This performance gap is clearly the result of larger companies having underperformed, while the stocks of relatively smaller companies have continued to strengthen. If this trend continues, the difference between market cap and equal weight can mean a big boost to your returns.
It should be noted that while equal-weight ETFs act as a more balanced representation of an index, they also can underperform during periods when larger stocks are flying. In addition, you should be aware that the expenses for equal-weight ETFs are typically higher than their market cap-weighted counterparts. These factors should all be evaluated when choosing core holdings.
Plus, you should compare the performance of equal-weight ETFs versus other index strategies such as low volatility, fundamental and active management. This will allow you to screen and select the best position to achieve your portfolio objectives given the future expectations of the market.
I think both RSP and QQEW should be added to your watch list for buying decisions with additional money down the road. However, given the lofty levels that the market is sitting at, I would not purchase these ETFs right now. I believe the risk-to-reward of higher stock prices vs. the potential for a correction make this a perfect opportunity to exercise patience.
But by purchasing these ETFs on a pullback and averaging into an attractive cost basis, you will be increasing your odds of success for a long-term core holding.
David Fabian is Managing Partner and Chief Operations Officer of Fabian Capital Management. To get more investor insights from Fabian Capital, visit their blog.