Morningstar Minute: Do equal-weighted ETFs have an edge?

For diversified Canadian equity ETFs, the traditional market-cap-weighted approach has yielded better results, but some sector-specific equal-weighted funds have outperformed.

Jeffrey Bunce, CFA 15 June, 2017 | 5:00PM

 

 

Jeffrey Bunce: Market-cap-weighted indices are ideal for low cost, passive investing, and this methodology is good for capturing broad market gains. A market-cap-weighted ETF, for the most part, is self-balancing and a low-turnover proposition. This keeps costs down and lets investors capture more of the index's return. In some instances though, market-cap-weighted indices may compromise diversification.

This issue is particularly acute in the Canadian market, where many sectors are quite concentrated with a limited number of large constituents monopolizing their respective sectors. ETFs utilizing a market-cap-weighted approach, such as those that track Canadian REITs, energy and utilities all expose investors to single-security risk and are skewed to large, established companies. One remedy is to pursue an equal-weighted approach. Here, turnover and costs may be higher but the investor receives a more balanced portfolio, albeit with a smaller average market cap.

So, which approach does better? Well, for a basket of large cap stocks in Canada, the Silver-rated iShares S&P/TSX 60 beats the equal-weighted Horizons equivalent over the past five years by close to 80 basis points, annualized. Here, the iShares fund uses its scale, efficient management and low costs to win out.

Comparing sector ETFs though, tells a different story. Three equal-weight sector ETFs offered by BMO have beaten the iShares market-cap-weighted equivalents by, on average, 1.2 percentage points.

Based on this limited comparison, going with a market-cap-weighted approach has worked for diversified large-cap exposure, but investors looking for specific sectors were better off with an equal-weighted approach.

For Morningstar, I'm Jeff Bunce.

About Author

Jeffrey Bunce, CFA

Jeffrey Bunce, CFA  Jeffrey Bunce, CFA, is a senior investment analyst for Morningstar’s Investment Management group.