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Can Equal Weighting a Portfolio Minimize Risk?

Can Equal Weighting a Portfolio Minimize Risk?
By Ron DeLegge, Editor
October 22, 2009

SAN DIEGO (ETFguide.com) – Over the past few years an energetic debate has been centered on the benefits of stock indexes that weight companies by key financial metrics or fundamentals versus traditionally constructed indexes that weight by a company’s market size. Far less attention has been focused on equal weighted portfolios. Can they help you to minimize risk?

Equal Weighting 101
While it may sound complex, the idea of equal weighting is quite simple.

For stock indexes, instead of weighting companies by their market size or market cap, each company is assigned a fixed or equal weight. In other words, each company within the index receives the exact same ownership percentage. This type of strategy prevents stocks with a large market size from dominating the performance and volatility of the index.

Most equal weighted ETFs are rebalanced quarterly to stay true to their investment objective.

Understanding the Strategies
The Rydex S&P Equal Weight ETF (NYSEArca: RSP) is one of the oldest ETFs of its kind. RSP assigns each one of the stocks within the S&P 500 a fixed 0.20 percent weight. As a result, mid and smaller company stocks have an equal say within the index and aren’t drowned out by larger stocks.

Because of its bias towards mid and smaller cap stocks, RSP has outperformed the S&P 500 (NYSEArca: SPY) so far this year. RSP has climbed 38.74% whereas SPY is up 21.43%.

Rydex also offers eight equal weighted S&P 500 industry sector ETFs. The fund holdings mirror that of the popular Select Sector SPDRs, but all stocks within the Rydex sector funds are given an equal assignment within the portfolio.

With this year’s resurgence of the equity market, financial stocks (NYSEArca: RYF), basic materials (NYSEArca: RTM) and technology (NYSEArca: RYT) have all been top performers. Not to be overlooked are energy stocks (NYSEArca: RYE), which have climbed 50.43% since the year’s start.

Consumer Staples (NYSEArca: RHS) and Healthcare (NYSEArca: RYH) are typically viewed as a defensive haven during a bear market or recession.

Sector Equal Weighting
Another twist on equal weighting is the ALPS Equal Sector Weight ETF (NYSEArca: EQL). EQL is an ETF of ETFs that invests equal proportions in each of the nine Select Sector SPDR funds. The fund is rebalanced back to its original weighting target every quarter.

Most equal-weight indexes are based at the stock level,” states ALPS Director of Product Research, Jeremy Held. “EQL is an important extension of the equal-weight concept in that it addresses sector risk, which we consider to be a much more important and fundamental risk to client portfolios than individual stocks.”

Held says, “An equal sector strategy minimizes the negative impact of any one sector by diversifying over multiple sectors.”

Identifying Equal Weighted ETFs
How do you know an equal weighted fund when you see one?

The Index Strategy Maps (see below) are a new financial tool that help you to distinguish between the various types of ETF indexes. The Maps consist of nine honeycombed shapes and each describes the exact indexing strategy of the fund.

     Index Strategy Map: Rydex S&P Equal Weight ETF (RSP)

 

The vertical axis explains how stocks or securities within the index are being selected. Next, the horizontal axis describes how the stocks or securities are being weighted. In the example listed above, RSP's stocks are selected with a passive strategy and subsequently given an equal weighting assignment.  

The Index Strategy Maps are part of ETFguide's free online database which allows you to search for ETFs by their exact index weighting methodology. It's a visual tool to help investors make informed investment decisions. The system was pioneered by Rick Ferri, CFA with Portfolio Solutions to alleviate the confusion between the thousands of indexes that exist. 

Conclusion
Can equal weighted portfolios help you to reduce risk? While there’s no full proof method for preventing market losses, equal weighting can help you to avoid over-concentrated stock positions.

During the 2000-02 bear market, many traditionally constructed index funds got clobbered because of too much exposure to large cap technology stocks. On the other hand, equal weighted indexes were impacted, but less so. 

The performance of equal weighted ETFs is generally best when mid and small cap stocks are outperforminglarge company stocks, which explains their market beating performance. Conversely, equal weighted ETFs are likely to fall harder and faster when mid and small stocks tank.

Finally, equal weighting is an interesting strategy, especially for investors with a bias that favors smaller growth oriented stocks.

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