When are equal-weighted index funds / ETFs preferable to market-cap-weighted funds?

Question

Many stock index funds and ETFs are traditionally offered as market-capitalization weighted, because the constituent indexes are composed like that. I understand the capitalization weighting reduces turnover and thus minimizes trading costs.

However, I have noticed new products on the market that change to an equal-weighted composition of an index instead.

When might an equal-weighted version of an index fund be preferable to a capitalization-weighted version? Is an equal weighted portfolio of stocks necessarily less volatile or providing better risk-adjusted returns than capitalization-weighted?

When might the capitalization weighting be preferred instead?

Answer 1

In market cap weighted index there is fairly heavy concentration in the largest stocks. The top 10 stocks typically account for about 20% of the S&P 500 index.

In Equal Weight this bias towards large caps is removed.

The Market Cap method would be good when large stocks drive the markets. However if the markets are getting driven by Mid Caps and Small caps, the equal weight wins.

Historically most big companies start out small and grow big fast in a short span of time. Thus if we were to do Market cap one would have purchased smaller number of shares of the said company as its cap/weight would have been small and when it becomes big we would have purchased the shares at a higher price.

However if we were to do equal weight, then as the company grows big one would have more share at a cheaper price and would result in better returns.

There is a nice article on on investopedia, also gives the comparison of the returns over a period of 10 years, where equal weight index has done good. It does not mean that it would continue.

Answer 2

Equal-weight ETFs remove the large cap bias found in most popular indexes. What results behaves very much like a small-cap or mid-cap index. Observe RSP vs IJR over a 5 year period:

IJR (iShares S&P SmallCap 600 ETF) vs RSP (Rydex S&P Equal Weight ETF)

I'm not sure if equal-weighting is worth the reduced efficiency. Mid-cap and small-cap funds have lower expenses (%0.20 for IJR vs %0.40 for RSP) and appear to do better over the long run. We don't know if that pattern will continue, but expense is one of the strongest long-term predictors of performance.

Answer 3

Equal weighted indexes are not theoretically meant to be less volatile or less risky; they're just a different way to weigh stocks in an index. If you had a problem that hurt small caps more than large caps, an equal weighted index will be hurt more than a market-cap weighted one.

On the other hand, if you consider that second rung companies have come up to replace the top layer, it makes sense to weigh them on par.

History changes on a per-country basis - in India, for instance, the market's so small at the lower-cap end that big money chases only the large caps, which go up more in a liquidity driven move. But in a more secular period (like the last 18 months) we see that smaller caps have outperformed.

Answer 4

As Dheer pointed out, the top ten mega-cap corporations account for a huge part (20%) of your "S&P 500" portfolio when weighted proportionally. This is one of the reasons why I have personally avoided the index-fund/etf craze -- I don't really need another mechanism to buy ExxonMobil, IBM and Wal-Mart on my behalf.

I like the equal-weight concept -- if I'm investing in a broad sector (Large Cap companies), I want diversification across the entire sector and avoid concentration.

The downside to this approach is that there will be more portfolio turnover (and expense), since you're holding more shares of the lower tranches of the index where companies are more apt to churn. (ie. #500 on the index gets replaced by an up and comer). So you're likely to have a higher expense ratio, which matters to many folks.