“Smart beta” is a term that has increased in popularity over the last year or so. The straightforward idea is that there are numerous problems with the way that traditional stock and bond market indices — and their tracking funds — are constructed.
Smart-beta indices and ETFs aim to overcome these issues by using screens and other measures to comb through parent indices, kick out the bad stocks and create a portfolio that is designed to outperform the broad-based index.
While that sounds an awful lot like active management, smart-beta ETFs adhere to rules and a human being has zero influence — as side from choosing the initial factors — when it comes to stock selection. Smart-beta basically combines the best features of active and passive funds into one package.
And even though some smart-beta ETFs use a wide range of screens, one of the simplest strategies has consistently yielded great results for investors: equal weighting.
Equal-weight ETFs could be your portfolio’s best friend.
Equal Weight ETFs Outperform
For smart-beta proponents, traditional indexing stinks. One of the major problems with standard indexing is that, along with all the “good” companies, you get the “bad” ones as well. That combination drags on potentially market-beating returns.
Secondly, as an individual stock gets more expensive, its index weighting can grow significantly. That leaves the index’s overall value vulnerable if the stock reverses course and begins to crash. Smaller, faster-growing firms can’t pull their weight, while larger, slower-growing ones have more influence on the index.
That’s where smart-beta comes in. However, you don’t need all the crazy screens or the high costs that come with them. Simply equal-weighting could be enough.
As easy as it sounds, equal-weighting is just that. Every stock in a parent index is allocated at the same amount. In the benchmark S&P 500, for example, Apple (AAPL) has about 4.05% weighting. In the equal weighted version of the S&P 500, AAPL is only about 0.20%.
That sort of difference between the traditional market-cap weighted fund and the smart-beta works to investors’ advantage in a few ways and manages to help the equal-weighted index outperform by a wide margin.
First, equal weighting easily allows for greater performance contribution from firms with smaller market capitalizations. AAPL can’t influence the index any more than aluminum manufacturer Ball Corporation (BLL), eliminating concentration risk.
In the regular S&P 500, if AAPL is having a bad quarter, BLL’s good quarter won’t be enough to potentially overcome Apple’s issues. The smaller companies in an equal-weight strategy outperform when larger stocks are not in favor and vice-versa.
How about a real-world example?
Equal-Weight ETFs in Action
Semiconductor giant Intel (INTC) is down about 10% this year. The Philadelphia Semiconductor Index — which is market-cap weighted — has INTC as its top constituent and weights the company at 8%. The S&P Semiconductor Select Industry Index — which tracks the same basket of stocks, equal-weighted — has INTC at just 2.6%. As of mid-April, the equal-weight index is up around 12.2% year-to-date, while the Philadelphia Semiconductor Index only returned 2.7% in the same time.
Over the long term, you’ll find the same story for equal-weighting indexes and their respective equal-weight ETFs.
Over the past 10 years, the S&P 500 produced an average total return of 8.2%. Not too shabby. However, the S&P 500 Equal-weight Index (EWI) managed to beat the benchmark index by a full 2 percentage points each year over the same time period. That’s a significant performance difference for basically doing no work.
Now, equal-weighting won’t work in every market or all the time. However, over long periods of time — which is why you’re invested in stocks the first place — the smart-beta strategy manages to trounce traditional market cap weighting by a lot.
Two Equal-Weight ETFs To Buy
Given the ability of equal-weight ETFs to beat traditional indexing over the long haul, investors should at least consider shifting some of their equity exposure to the strategy.
Luckily, the smart beta explosion has coincided with the ETF boom and there are several funds to choose from. Many, like the Oil & Gas Equipment & Services SPDR (XES), don’t even highlight that they are equal-weighted.
The biggest and perhaps best is the Guggenheim S&P Equal Weight ETF (RSP). The $11.5 billion ETF was the first to pioneer the equal-weight strategy and tracks the previously mentioned S&P 500 EWI. And as we’ve said before, the EWI has managed to crush the broader index by a lot over the longer term. The RSP has managed to produce a market-beating 11.86% annual return since its inception in 2003.
Most smart beta funds are quite expensive to own, zapping some of the return potential. After all, if you’re paying 0.90% in fees, besting the parent index by 1% doesn’t really matter. However, unlike most equal-weight ETFs, the RSP has managed to post returns at pretty cheap expense ratio. The RSP only charges 0.40%, or $40 per $10,000. That amount is actually cheaper than some traditional products tracking the S&P 500.
Another choice could be the Direxion NASDAQ-100 Equal Weighted ETF (QQQE).
The tech-heavy NASDAQ is where the strategy behind equal-weight ETFs can really pay off. In the NASDAQ, AAPL has a weighting of 14% and Microsoft Corporation (NASDAQ:MSFT) has a weighting of 7%. While you can argue that these mature tech firms are still viable investments to hold, their massive growth days are certainly behind them. Even Apple is starting to show some cracks in its armor (iWatch anyone?).
In the QQQE, all the firms are weighted at 1%, giving plenty of non-tech and smaller tech names the chance to shine. Again, that strategy has helped the QQQE managed to outperform its parent index. And like the RSP, QQQE is cheap compared to most equal-weight ETFs. The fund only charges 0.35% in expenses.
The Bottom Line: When it comes to smart-beta, simple strategies could be best. Equal-weight ETFs have proved to be one of the best ways to gain additional returns.
