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Summary Most investors look only at capital-weighted indices. They miss two positive anomalies of equal weight. Here are equal-weight ideas and ETFs for passive investing and tactical allocation. Capital-weighted indices in the broad market and specific sectors are getting all the attention of investors. This article aims at proving that equal-weighted indices are better investment vehicles for passive investing and tactical allocation. We will stay in the S&P 500 universe. A few words of theory The statistical bias in favor of an equal weighted set of stocks over the same set weighted on market capitalization has two reasons: Size effect: Lower-range large-caps usually perform better than mega-caps. Rebalancing: Periodically equalizing position sizes in dollar amount among a big set of stocks is a simplistic “buy-low-sell-high” strategy. Simplistic, but not stupid. The interest bias in favor of capital-weighted indices has also good reasons: It is a good representation of real economic activity. Inheritance of the pre-computer era, capital-weighted indices are easier to calculate manually. They are linear functions of share prices, adjusted of structural and corporate events (component list modifications, splits, public offerings, buybacks). It generates less transaction costs for a mutual fund or ETF following it. Equal-weighted S&P 500 The next chart shows in red the equity curve of all S&P 500 stocks, equal-weighted rebalanced on weekly opening between January 1999 and September 2015. The blue line is SPY . In both cases, dividends are accounted and reinvested. It is impossible to implement as a strategy for an individual investor because of the capital needed to absorb transaction costs. Moreover, there is an ETF for that: the Guggenheim S&P Equal Weight ETF (NYSEARCA: RSP ). Since inception on 4/24/2003, it has an annualized excess return of 2% over SPY, making it a better instrument of passive index investing. On the same period, the theoretical annualized excess return of equal-weight S&P 500 with dividends is 3.5%. The difference can be explained by trading costs, management fees, rebalancing frequencies. Next chart: RSP in red versus SPY in blue since 4/24/2003: (click to enlarge) S&P 500 with sectors in equal weight The next chart shows the equity curve of an equal weight portfolio of the 9 Select Sector SPDR ETFs rebalanced weekly: utilities (NYSEARCA: XLU ), energy (NYSEARCA: XLE ), materials (NYSEARCA: XLB ), financials (NYSEARCA: XLF ), healthcare (NYSEARCA: XLV ), industrials (NYSEARCA: XLI ), IT & telecom (NYSEARCA: XLK ), consumer staples (NYSEARCA: XLP ), and consumer discretionary (NYSEARCA: XLY ). Here, the size effect is questionable, but the rebalancing bias applies. (click to enlarge) Individual sectors in equal weight Guggenheim has also sector equal-weight ETFs. The next table compares their annualized returns with the Select Sector SPDR series since inception date (11/1/2006), and the theoretical return of stocks rebalanced weekly in equal weight: Sector Stocks Eq. Weight weekly Eq. weight ETF Ann. return Cap. weight ETF Ann. return Cons. Disc. 9.76% (NYSEARCA: RCD ) 8.63% XLY 9.96% Industrials 9.08% (NYSEARCA: RGI ) 7.64% XLI 7.01% Cons. Staples 12.61% (NYSEARCA: RHS ) 11.72% XLP 9.92% Materials 7.63% (NYSEARCA: RTM ) 6.73% XLB 5.16% Energy 2.83% (NYSEARCA: RYE ) 1.97% XLE 3.26% Financials 2.46% (NYSEARCA: RYF ) 0.02% XLF -2.63% Healthcare 14.91% (NYSEARCA: RYH ) 14.18% XLV 10.96% Technology 8.41% (NYSEARCA: RYT ) 6.95% XLK 8.32% Utilities 7.24% (NYSEARCA: RYU ) 6.33% XLU 5.59% In theory, equal weight brings a better or similar return in all sectors, except energy. After management fees and tracking errors, the consumer discretionary and technology equal-weight ETFs are also failing. Equal weight of equal-weighted sectors As a last paragraph, here is the return since the inception of the Guggenheim ETFs in equal-weight rebalanced weekly compared with the Sector SPDR ETFs in equal weight, RSP and SPY. 1/01/2006-09/16/2015 Guggenheim series eq. weight SPDR series eq. weight RSP SPY Ann. Return 8.35% 7.16% 7.43% 6.31% The solutions with individual stocks in equal weight for each sector work better (1st and 3rd columns), which makes sense: size effect is more beneficial. For an individual investor seeking an equal-weight strategy on the broad index, RSP may be a better solution than the Guggenheim series in equal weight after transaction costs, depending on transaction fees and portfolio size. Conclusion With the exception of the energy sector, equal weight has been systematically superior to capital weight in the S&P 500 universe on the 2 last market cycles (1999-2015). In ETF implementations, fees and tracking errors result in a lag for 2 other sectors. Investors can find here useful investing instruments and ideas for passive investing and sector tactical allocation. Data and charts: Portfolio123 Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: I short the S&P 500 for hedging purposes Scalper1 News
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