Introduction

Equally-weighted ETFs can be a powerful tool in any investor’s portfolio. By providing an equal weighting to every constituent in an index, these ETFs can reduce concentration risk and offer more balance exposure versus their traditional market-cap-weighted counterparts.

S&P Dow Jones Indices (SPDJI) created the first equally-weighted index in January 2003, the S&P 500 Equal Weight index, a construction methodology that gives each stock an equal weighting at the start of each rebalance date.

The strategy was created in response to concerns that market-cap-weighted indices can exhibit momentum bias – the concept of winners continuing to get a larger weight – especially when heading towards the end of a market cycle when valuations become frothy.

As a result, equal weighting offers a natural option for investors wishing to reduce concentration risk within their portfolios.

Factor exposure

While reducing exposure to the momentum factor, equal-weight ETFs have a natural bias to value – given these stocks become value stocks following a drop in market cap relative to their earnings – and size. 

The small-cap bias is the crucial difference between equal and market-cap weighted strategies. While market-cap-weighted ETFs favour the largest stocks in the universe, equal-weight ETFs place greater emphasis on small-cap stocks.

This can lead to greater volatility as small caps typically exhibit greater price volatility, however, it also leaves investors exposed to companies with the highest growth potential.

According to data from Liberum Capital, the size factor bias in the S&P 500 Equal Weight index is approximately three times as important as the value bias.

Risks

While the size factor bias, and resulting volatility, is one of the most important considerations of equal-weight ETFs, this indexing approach leads to higher turnover and transaction costs.

To maintain the equal allocation to each constituent in the index, equal-weight ETFs require more frequent rebalancing versus market-cap-weighted strategies.

According to research conducted by Solactive, the more an equal-weight index rebalances, the greater its returns. For example, a daily rebalanced portfolio outperformed the weekly rebalanced, quarterly rebalanced and finally the portfolio that never rebalanced.

However, rebalancing too frequently would make turnover costs too high which means index providers must strike a balance when constructing an equal-weight index.

Furthermore, an equal-weight approach lowers exposure to industry leaders which can often drive returns for an entire sector. The relatively low exposure to these companies means investors can miss out on big returns.

Final view

Equal-weight ETFs offer a great way for investors to diversify away from the biggest companies within an industry, especially when an index becomes overconcentrated, however, it is important to be aware of the natural small-cap bias and high turnover costs that come with this indexing approach.