We love index funds here at The College Investor, and we've recommended several in our Guide to Investing. However, there's a new type of index fund that is gaining in popularity, and one that I think has a lot of merit – equal weighted index funds.
An equal weighted index fund is just like it sounds – everything inside the index fund is equally weighted. This differs from other index funds, in that most are capitalization-based, meaning stocks with higher market capitalization (or value) are held as a higher percentage of the fund. Let's see how that really breaks down…
What is an Equal Weighted Index Fund?
Let's use the S&P 500 for this example. You know that the S&P 500 is composed of the 500 largest stocks in the United States.
Right now, a standard S&P 500 index fund (let's use SPY), has the following Top 5 Holdings:
- Apple (AAPL) – 3.67%
- Microsoft (MSFT) – 2.37%
- Exxon Mobil (XOM) – 1.85%
- General Electric (GE) – 1.54%
- Johnson & Johnson (JNJ) – 1.53%
So, as you can see, there is a much larger percentage of the fund in several stocks, which can skew returns if these stocks perform well or poorly. In fact, that happened last week with Apple – many broad index funds were up much higher than the market, simply because of the weighting of Apple and Microsoft in their portfolios.
Let's look at what equal weighting does. One of the most popular equal-weighted funds is the Guggenheim S&P 500 Equal Weighted ETF (RSP).
If you look at the holdings of RSP, all of the stocks in the fund are at 0.22%, since the fund is equal weighted. This changes the dynamic of the performance of the fund, since no single holding can overtake the others, and performance is equalized.
How Equal Weighted Index Funds Outperform
The balance that you get with an equal weighted index fund really comes into play when you chart out performance over time. Here is a side-by-side comparison of SPY and RSP over the last decade.
The red line is RSP, the equal weighted portfolio, and the blue line is SPY, the standard capitalization weighted portfolio.
Over the last decade, RSP has returned 82.49% vs. 64.41% for SPY over the same period.
The key to this success is balance. At the top, no single holding that may underperform can drag the portfolio down, while at the bottom, faster growing stocks get more weight than in a capitalization-based index. This allows for more growth, similar to what you see in small or mid cap funds.
Drawbacks to Equal Weighted Index Funds
The biggest drawback to equal weighted index funds are higher expense ratios. These funds have higher expenses because they have daily costs of maintaining balance in their portfolio. While an ETF like SPY will only trade when major changes happen, equal weighted funds have to continually trim overweighted holdings to maintain the balance. Think of it like a daily portfolio rebalancing act.
The second big drawback to equal-weighted funds is that the gap in performance vanishes as you move from large cap funds to mid and small cap funds. In fact, the equal-weighted index funds are basically even at the mid cap and underperform at the small cap level.
Mid Cap Equal Weighted Funds
Here, we look at the Guggenheim Russell MidCap Equal Weight ETF (EWRM) vs. the iShares Russell MidCap ETF (IWR). You can see over the last 5 years (total time of fund's existence), performance of the two funds has basically been even, with a slight underperformance of the equal-weighted fund.
Over the period, EWRM returned 60.30% vs. 63.53% for IWR.
Small Cap Equal Weighted Funds
Here, we look at Guggenheim Russell 2000 Equal Weight ETF (EWRS) vs. the iShares Russell 2000 ETF (IWM). You can see that the equal weighted fund actually underperformed the benchmark index in this case.
Over this period, ERWS returned 34.45% vs. 50.94%% for IWM. That is over 15% underperformance, not including the higher expense ratio.
Lessons on Equal Weighted Index Funds
The biggest lesson learned is that, if you're looking for a large cap index fund, you should look at equal weighted funds. These funds are great for large cap investors because:
- It dampens underperformance of top holdings
- It increases performance of “smaller cap” holdings
- It has a bias towards growth stocks because of the equal weighted
Second, we learned that these rules don't apply to mid cap and small cap index funds for the same reasons. Equal weighted funds are not good investments at the small cap level because:
- Small caps have a tendency towards extreme growth, and you lose that with equal weighting
- Larger holdings in small cap funds are the ones you want to hold, but you lose exposure to
Finally, it's important to keep in mind the higher expenses when investing in equal weighted index funds.
Reference of Popular Equal Weighted Index Funds
Here are the most popular equal weighted index funds, in case you're interested in investing.
- RSP – Guggenheim S&P 500 Equal Weighted Index Fund
- QQEW – First Trust NASDAQ 100 Equal Weight Index ETF
- EWRI – Guggenheim Russell 1000 Equal Weight ETF
- EWRM – Guggenheim Russell MidCap Equal Weight ETF
- EWRS – Guggenheim Russell 2000 Equal Weight ETF
- Basic Materials – RTM – Guggenheim S&P 500 Equal Weight Materials ETF
- Consumer Discretionary – RCD – Guggenheim S&P 500 Equal Weight Consumer Discretionary ETF
- Consumer Staples – RHS – Guggenheim S&P 500 Equal Weight Consumer Staples ETF
- Energy – RYE – Guggenheim S&P 500 Equal Weight Energy ETF
- Financial Services – RYF – Guggenheim S&P 500 Equal Weight Financial Services ETF
- Health Care – RYH – Guggenheim S&P 500 Equal Weight Health Care ETF
- Industrials – RGI – Guggenheim S&P 500 Equal Weight Industrials ETF
- Technology – RYT – Guggenheim S&P 500 Equal Weight Technology ETF
- Utilities – RYU – Guggenheim S&P 500 Equal Weight Utilities ETF
- EWEF – Guggenheim MSCI EAFE Equal Weight ETF
- EWEM – Guggenheim MSCI Emerging Markets Equal Weight ETF
- EWAC – Guggenheim MSCI All Country World (ACWI) Equal Weight ETF
What are your thoughts on equal weighted index funds? Do you invest in these in your portfolio?