The WSJ featured an interesting article titled “Spice Up the Index-Fund Formula:”
Smart investors have long known that steady, boring index funds offer excellent long-term performance. But a twist on the tried-and-true indexing formula may juice returns — especially if smaller stocks continue to lead the market back from the crash.
The strategy, known as equal weighting, gives every stock in an index the same influence, regardless of size.
That means with index funds that track the Standard & Poor’s 500-stock index — and follow this approach — Exxon Mobil, No. 1 with a market value of $352 billion, is no more meaningful to performance than No. 500 Dynegy, which has a market value of about $2 billion. With traditional indexing methods, stocks with the biggest market capitalization wield the most clout.
To understand how traditional indexing favors larger stocks, consider that the 42 largest companies in the capitalization-weighted S&P; 500 recently accounted for 50% of its market value. Put another way, 42 stocks had the same impact as the remaining 458.
Exxon Mobil, for example, represents 4.4% of the cap-weighted S&P; 500. In the equal-weighted benchmark, however, the oil company represents only 0.2% of the index — the same as the other 499 companies.
With equal weighting, S&P;’s Mr. Stovall says, “you spread the risk to all 500 companies and emphasize smaller companies, taking advantage of the small-cap effect.”
Equal weighting’s appeal is even more evident with focused sector funds. For instance, an equal-weighted ETF tied to the energy sector, SPDR S&P; Oil & Gas Exploration & Production — where Exxon Mobil makes up 2.6% of the fund — is up around 23% so far this year.
The capitalization-weighted ETF iShares Dow Jones US Energy — where Exxon Mobil commands a 22% share — has gained about 10%.
“If you’re worried about over-concentration [in a few stocks], you might consider an equal-weighted sector fund,” says Matt Hougan, editor of IndexUniverse.com. “If Exxon Mobil were to announce something awful and its share price drops — but it has nothing to do with the energy market — and you were invested in the Dow Jones US Energy fund, you’re going to take a major hit. In an equal-weighted fund, it would have a much lower impact.”
To me, reducing volatility in the overall index, when a major company makes a earthshaking bad announcement, is something positive. This does not mean you can blindly buy and hold equal weighted funds; you still need to apply a sell stop discipline to guard against the market reversing its trend and moving into bearish territory.
In my advisor business, I favor using equal weighted ETFs like RSP in conjunction with my hedge strategy, since they tend to give us a better performance compared to the plain vanilla S&P; index.