Now May Be A Good Time To Add Equal-Weighted ETFs To Your Portfolio

By: Andrew J. Willms, President and CEO of The Milwaukee Company

ETFs that track the S&P 500 Index and Nasdaq 100 index are an important part of many investors’ portfolios. Since their introduction in the 1990’s, these ETFs have been promoted as a simple way to passively invest in a diverse group of large U.S. companies.

However, both indexes have become increasingly focused on just a handful of stocks. More specifically, about a quarter of the SPDR S&P 500 Trust (an S&P 500-tracking ETF that trades under the ticker SPY) is invested in just 5 stocks: Facebook, Amazon, Apple, Alphabet/Google and Microsoft (the so-called “FAAMG” stocks). And if you add Tesla to the group, the 6 companies account for about half of the holdings of Invesco QQQ Trust (a Nasdaq 100 tracking ETF that trades under the ticker QQQ) of the Nasdaq 100.

The reason these indexes, and the ETFs that track them, have become so concentrated is that the indexes are market-weighted. In other words, companies with the largest market capitalizations[1] will have the greatest allocations (or weights) in the index. The tremendous growth in the market caps of Facebook, Apple, Amazon, Microsoft and Alphabet/Google during the pandemic has resulted in these 5 companies constituting a much bigger percentage of these indexes.

This has led to questions about concentration risk which refers to the possibility that poor performance by just one or two of an index’s constituents will drag the entire index down. We’ve seen an example of this during September, as a sell-off of the FAAMG stocks over high valuation fears has led to a sharp drop in the price of both QQQ and SPY. Then again, on a year-to-date basis, both the S&P 500 and the Nasdaq 100 have benefited greatly from the surge in FAAMG stocks. Year to date, 60% of the stocks in the S&P 500 had a negative return but thanks to FAAMG, the index is up approximately 4%.

So, one might argue that investing in the S&P 500 and the Nasdaq 100 is a good way to ride the mega-tech stock wave. But if that is the objective, then why not simply buy the FAAMG stocks? Moreover, the whole purpose for index funds has been to provide diversification, not concentration.

Investors who are looking for diversification may do well to consider rotating at least a part of their investment in market-weighted index ETFs into equal-weighted index funds. As their name implies, these funds invest an equal amount in each company included in the index, regardless of market cap. For example, an equal-weighted ETF that tracks the SPY 500 would have just 1.25% of the fund invested in Facebook, Apple, Amazon, Microsoft and Alphabet/Google combined. The result is a much more balanced exposure to the companies included in the index than their market-weighted counterparts.

There are dozens of equal-weight ETFs. One of the largest is the Guggenheim S&P 500 Equal Weight ETF (RSP), which was established in 2003. Another is First Trust Nasdaq-100 Equal Weighted Index Fund (QQEW) which started trading three years later.

A drawback to equal-weighted ETFs are their considerably higher expense ratios. Both RSP and QQEW come with an expense ratio exceeding 50 basis points (one-half of one percent). By comparison, the expense ratio of QQQ is 20 basis points, and for SPY its just 9.

One reason for equal-weight funds’ higher fees is the need for these ETFs to rebalance their holdings more frequently in order to keep the allocations to each of their components equal. Rebalancing results in equal-weighted ETFs selling ETF stocks whose prices have risen, and then adding to stocks whose prices have fallen. Equal-weight detractors describe this contrarian approach as selling winners and buying losers. Supporters say equal-weights sell high and buy low.

In short, market-weighted ETFs emphasize the stocks of companies that are trending higher. By contrast, equal-weighted ETFs are designed to provide better balance and greater exposure to less expensive stocks. Which style will perform best depends on market conditions, which is why it may make sense to invest in both.

[1] A company’s market capitalization is determined by taking the share price of its stock and multiplying it by the number of shares outstanding.


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