Financial advisors in search of lower-cost equity funds with higher long-term return potential might consider exchange-traded funds (ETFs) that strive to replicate equal-weight indices.

Unlike the major long-standing indices, such as the S&P 500 composite index, that weight their stock exposure based on the market value of the outstanding shares of the companies comprising the index, equal weighting gives the same weight to each stock in the index.

Equal weighting as an index methodology results in greater exposure to small- and mid-size companies than does market capitalization-weighted indices. This reduces the concentration in larger stocks that most market-cap indices exhibit.

Also, as higher-priced growth stocks have greater aggregate market values than do comparatively lower-priced value stocks, equal weighting tends to tilt toward value stocks.

Furthermore, equal weighting typically results in a more diversified and stable sectoral exposure than a market-cap approach because sector allocation is based upon the number of companies within a sector instead of the price-influenced aggregate market cap of the companies.

Equal weighting also offers the potential for modest return enhancement from the rebalancing of individual stocks to target weights, thus capitalizing on their volatility.

Although there are several equal-weight indices now available, the longest-standing is the S&P 500 equal-weight index (S&P EWI). From January 1990 through August 2014, the 11.5% annualized return of the S&P EWI handily outperformed the 9.6% return of the S&P 500. Attribution studies have found that the drivers of this outperformance are greater exposure to both the “small-cap” and “value” effects.

However, with the S&P EWI’s greater exposure to smaller stocks, the volatility of this index was higher – with an annualized standard deviation of 18.6% vs 16.3% for the S&P 500. The S&P EWI also suffered moderately higher drawdowns.

Nevertheless, using risk-adjusted metrics such as the Sharpe ratio – which measures reward-to-volatility and reward-to-downside, respectively – the S&P EWI ranked ahead of the S&P 500.

Thus, even allowing for the S&P EWI’s greater volatility and drawdowns, that index outperformed over this period.

We also compared the S&P/TSX 60 equal-weight index (S&P/TSX EWI) vs the market cap-weighted S&P/TSX 60 index: from October 1999 to August 2014, the 10% annualized return of the S&P/TSX EWI handily outperformed the 7.9% return of the S&P/TSX 60. Interestingly, the S&P/TSX EWI had lower volatility and less severe drawdowns than did the S&P/TSX 60, reflecting in part the former’s lower exposure to cyclical stocks and higher allocation to defensive stocks.

Equal weighting has its drawbacks: its higher weighting of smaller-cap stocks means that this strategy underperforms in markets that favour large-cap stocks, such as during the late 1990s; and equal weighting typically results in higher turnover and trading costs than a market cap-weighted index. And, although an equal-weight index tends to be tilted to value stocks overall over time, this approach does suffer from “style drift.”

Finally, the ETFs that strive to replicate equal-weight indices typically have higher management expenses than those based upon broader, market cap-weighted indices.

Michael Nairne is president of Tacita Capital Inc. of Toronto, a private family office and investment-counselling firm. The company, its principals, employees and clients may own securities mentioned in this article.

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