Is Your Index Tracking ETF Overweight(ed)?

By: Andrew J. Willms

President and CEO of The Milwaukee Company

Frequent readers of my contributions to this newsletter know that as a general rule I prefer investing in low-cost, passively managed exchange traded funds, as opposed to actively managed mutual funds or stocks of individual companies. The reasons include:

  • Index ETFs are simple in structure and easy to understand.

  • Passive ETFs that track a particular index or benchmark simply mirror the index’s holdings without seeking to outperform it. This allows for lower management fees, less turnover, and - if a slew of academic studies are to be believed - a greater probability of success by delivering superior returns than most active managers.

  • Index ETFs allow you to build a well-diversified portfolio with a just a small number of securities.

  • Index ETFs provide access to sectors where it may be more difficult to buy and sell individual stocks and bonds.

  • ETF shares trade like stocks, meaning you can trade them anytime during market hours. As a result, you can see how their prices change throughout the trading day.

  • Typically, ETFs tend to be substantially more tax efficient compared with their mutual fund brethren because investors in passively managed index ETFs are typically only taxed when they sell their ETF shares.

  • Most ETF sponsors publicly disclose the assets held by the ETF every day.

That said, not all index-tracking ETFs are created equal. Things to consider when selecting an ETF include:

  • Is the index being tracked well-established and widely followed, or simply a creation of the ETF manager that he or she can modify as needed to fit his or her purposes?

  • Are the fees being charged by the ETF sponsor competitive?

  • Are shares issued by the ETF traded in larger enough volumes to make them easy to sell? Similarly, it is important that the ETF have a minimum amount of assets, such as $100 million or more.

  • How closely does the ETF track the index it follows? ETFs with a history of so called “tracking error” should be viewed cautiously and, in some cases, avoided entirely.

  • Is the index market-weighted, equal-weighted, fundamentally weighted or constructed using another methodology?

It is this last characteristic that I would like to focus on - specifically, market vs. equal weighting.

Most index-tracking ETFs are market-weighted. This means that the amounts invested in a given stock is proportional to the size of the company’s value. The larger a company’s market capitalization (as measured by multiplying the number of outstanding shares by the price per share), the greater the amount allocated to the company’s stock by the ETF manager.

By comparison, as the name implies, an equal-weighted ETF invests an equal amount in all of the companies included in the index. For example, if there were 100 companies included in an index, then an equal-weighted ETF would invest 1% in each company.

This difference in weighting schemes means that market weighted ETFs provide greater exposure to stocks of larger companies, while equal-weight index funds invest more dollars in medium and smaller companies.

Good arguments can be made for and against both market-weighted and equal-weighted ETFs, and I do not believe either approach is inherently better or worse than the other. However, market conditions can favor one type over the other, and current market conditions might give some equal-weighted ETFs an advantage over their market-weighted counterparts. Here’s why.

The Covid-19 pandemic has led to a surge in the market capitalization of a limited number of mega-cap technology companies whose business models were well-suited to serving the needs of folks who have been working, shopping, and entertained at home. The result has been an increased concentration in the stocks of Facebook, Apple, Amazon, Netflix Microsoft and Google (a.k.a Alphabet) by market-weighted index funds that include the so-called “FAANMG” stocks amongst their constituents.

Initially, the stellar performance of the FAANMG stocks led to market-weighted versions of the Nasdaq 100 and the S&P 500 to significantly outperform their equal-weighted counterparts. But as the FAANMG stocks became increasingly expensive, more investors have shifted their attention to less expensive, smaller company stocks. As a result, equal-weighted ETFs have begun to make up lost ground.

The following chart compares the performance of ETFs that track a market-weighted S&P 500 ETF (SPY) to that of an equal-weighted version (RSP) over the past 3 months.

Similarly, the equal-weighted version of the Nasdaq 100 (QQQE) has been outperforming the market weight alternative (QQQ) over the same time frame as well.

Recent performance aside, why might equal-weighted ETFs be more appealing at the moment? One reason is that oversized allocations to a few stocks reduces diversification and increases concentration risk; that is, the risk of underperformance of the few can negatively impact the entire index.

Mean reversion can also cause havoc on excessively concentrated index ETFs. Mean reversion refers to the tendency for stocks to revert to their long-term return mean (average). Mean reversion lends credence to the suggestion that the smaller companies will recover ground last to the FAANMG stocks in the months and years ahead.

If you are optimistic about the prospects of the largest components that make up an index, or you prefer to overweight companies that have been outperforming as of late, then a market- weighted ETF is a strategic way to try and profit from your optimism.

If, on the other hand, diversification is important to you, you are of the opinion that FAANMG stocks have become overly expensive, or you agree with Newton that what goes must come down, then equal-weighted ETFS are worth a closer look.


This Week’s Market Commentator’s Podcast

In this week’s podcast, I talk with Dan Dumjic, a Principal in Taxable Fixed Income at Piper Sandler & Co., about the state of the fixed income market, the impact rising rates and inflation could have on fixed income investors, and reasons to favor mortgage-backed securities in a rising rate environment.

You can listen to our discussion HERE.

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