The pros and cons of equal-weighted ETFs

They provide diversification and rebalancing benefits over cap-weighted ETFs, but come with higher fees and volatility, says Invesco Canada's Christopher Doll.

Christian Charest 30 July, 2018 | 5:00PM
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Christian Charest: For Morningstar, I'm Christian Charest. There are many ways in which index providers and the ETFs that track them have tried to improve on the performance of traditional indexing. These strategies are often called smart beta, while here at Morningstar we prefer the term strategic beta. By far, the simplest of these approaches is equal weighting, and I'm here today with Christopher Doll, Vice President of ETF Sales and Strategy at Invesco Canada, to talk about the pros and cons of that approach.

Christopher, thanks for joining us today.

Christopher Doll: My pleasure. Thank you for having me.

Charest: So, to start with, can you please explain what we mean by equal weight?

Doll: Equal weight is really the simplest of smart beta or what you term strategic beta strategies. It effectively takes the universe of stocks in an index and weights them equally across all the securities.

Charest: So, what are the benefits to the equal weight strategy?

Doll: From my perspective, the biggest benefit is the diversification that you get. In a market-cap-weighted strategy what happens is, you end up owning more of the larger stocks because they have a greater weight in the index. In an equal weight strategy, you diversify it across a broader range of securities and sectors within the index.

Charest: Can you give us some examples of how that can be a benefit?

Doll: Yeah. So, in certain market conditions or certain market environments, the concentration of stocks into one sector that is performing really well, you benefit in a market-cap-weighted strategy when the markets are going up, but then you also are impacted negatively on the downside. So, think, for example, of Nortel back in 2000 when Nortel was doing really well the market went up. Nortel's performance drove the market up and then subsequently when the performance turned it pulled the market down. In an equal weight strategy, where you have a much smaller weight to that single stock exposure, your performance wasn’t as impacted by that single stock as you would have been in the market-cap-weighted strategy.

Charest: And we are seeing this play out more recently with the so-called FAANG stocks led by Facebook which has recently had some troubles.

Doll: The FAANG stocks [Facebook, Apple, Amazon, Netflix and Alphabet/Google] have really been the catalyst to what's been driving the markets over the last 18 to 24 months, I would say. In 2017 for example the 14% in those securities drove about 25% of the returns of the market. In 2018 we're seeing about 50% of the returns in the S&P 500 being driven by those FAANG stocks. To your point more recently Facebook's earnings that came out weren’t what the market was expecting and that’s had a big impact on the performance of those stocks. And that will likely have a bit of a divergence in performance between the broader S&P 500 index versus an equal weight strategy that doesn’t have as great an exposure to those FAANG stocks as the market-cap-weighted index do.

Charest: So, diversification is one of the main benefits. What are some of the other advantages of the equal weight strategy.

Doll: The biggest one is the re-balancing effect. So, with an equal weight strategy in this index specifically from S&P they rebalance on a quarterly basis. The reason why they do that is, they have to bring the weights back into that equal weight status, because you'll have market effect and the security will flow throughout the quarter and then we bring it back in line. What effectively is happening when that rebalance takes place is you are harvesting your winners and you are reinvesting in your losers. So, it's a constant sort of contrarian rebalancing that adds value over time. And we've seen that in a number of smart beta strategies, part of the return of the value of a smart beta strategy is that disciplined rebalancing effect in the portfolio. On the flipside a market-cap-weighted strategy would just let that weight continue to ride as long as the stock is going up, and then if leadership of that stock, and their performance turns like we're seeing with Facebook, it would go down and the market would go down subsequently with that stock.

Charest: And the equal weight strategy also benefits from some factor exposures. Can you tell us about that?

Doll: So, when we think of smart beta or strategic beta strategies, a lot of the economic thesis behind these strategies is rooted in factor investing. And so, with an equal weight strategy because you are tilting away from the largest cap names in the market-cap-weighted index you are naturally going to tilt a little small cap in the case of the S&P 500 Equal Weight Index you are tilting toward mid-cap names because it is a large cap index as your starting universe. You also end up tilting a little bit more value. So, because the leadership of the market-cap-weighted index is driven by the larger stocks, there is more momentum in a market cap weighted strategy, and in an equal weight strategy you end up taking on more value exposure than the market.

Charest: We've talked about some of the benefits. What are some of the drawbacks of this strategy.

Doll: There are a few drawbacks. You do end up having slightly higher turnover in the portfolio. It's not significant. Over the last five years in the strategy that underlies our Canadian strategy we average around 20% a year, and so that is fairly reasonable for a smart beta strategy. But it's a lot more than your traditional S&P 500 market-cap-weighted strategy.

Charest: Equal weight ETFs have been around for a while in Canada. But they tend to be popular more among the some of the more sector-focused strategies, or strategies that involve a very small number of stocks. Now, at Invesco you launched an equal weight strategy that centers around the S&P 500, which of course has 500 holdings. Is that more challenging to implement that kind of strategy on such a broad index.

Doll: Not necessarily, no. So the strategy is the 500 most liquid stocks arguably in the world because the starting universe is the S&P 500. So our ability to implement a strategy, do the quarterly rebalancing is very seamless and so while it's true that most of the equal weight offerings available in Canada have been very sector niche plays, the true benefit of the equal weighting strategy can be seen in the performance success of equal weight versus broad equal weight on the S&P 500 versus the market cap, and we’ve seen that persist over market cycles and over time in the live environment.

Charest: Now an S&P 500 index is normally seen as a core holding for the U.S. equity portion of someone's portfolio, but would you consider this ETF -- the ticker is EQL -- would you consider that a core holding given that it has a much smaller-cap profile.

Doll: Absolutely. Even though you do tilt a little small cap -- and its more mid-cap than small cap -- even though you do tilt that way, it still is the same 500 names that you get in the broader index but with less risk from a security concentration or sector concentration standpoint. So in essence you are reducing your overall security exposure risk. On the flipside though, you do pick up a little bit more volatility because you are tilting to those smaller names, but that volatility is offset by excess returns over the market cap weighted index.

Charest: The ETF EQL it's live performance record is very short; the fund was just launched in May. But what does the back-tested result look like and how does it compare to the standard S&P 500.

Doll: Even though the strategy was launched here in Canada recently in May, it is based on an underlying U.S.-listed product that has over 15 years of live performance data. And so I prefer to point to that track record. Because you can get a sense of actually how it did with all the implementation costs, the turnover that takes place in the quarterly rebalancing, the fees, you can see that the performance over time has outperformed the market-cap-weighted index in a live environment. So, if you compare the underlying, in our Canadian listed we're buying that underlying U.S.-listed -- RSP is the ticker down in the U.S -- if you compare RSP against SPY which is the broad S&P 500 index, you can see that outperformance over time.

Charest: Christopher, thank you very much for explaining all this to us today.

Doll: My pleasure, thank you for having me.

Charest: From Morningstar I'm Christian Charest. Thank you for watching.

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Christian Charest

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