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May 04, 2015 at 08:00 PM
Over the past 50 years, the nature of index investing has changed radically, as index-based funds like ETFs have taken a prominent place in portfolio management. For financial professionals and investors alike, indices serve as both templates for investment products and as yardsticks for judging active managers.
In the ETF universe, there are three basic indexing choices: (1) indices that weight securities by their market capitalization or size; (2) indices that weight all securities equally; and (3) indices that weight securities using alternative factors like dividends, earnings, or a combination of factors. While this latter indexing strategy is sometimes referred to as “smart” beta, alternative beta is actually a more accurate label.
The introduction of newer indexing strategies has sparked debate and controversy about the investment viability of traditional market cap weighted indexes. While the long-term performance results for traditional indexes are enviable, alternative indexes aim to improve the potential for even better returns.
Most Popular Index
The S&P 500 in its present form began on March 4, 1957. It is the most widely held equity index in the U.S and one of the most popular benchmarks around the globe.
The index consists of 500 large company stocks including familiar names like Apple, Exxon Mobil, Johnson & Johnson and General Electric. The S&P 500 is a market cap weighted index, which means its performance and volatility is influenced by the stock components with the largest market size while smaller companies have less effect.
Although popular ETFs like the SPDR ETF (SPY) and iShares Core S&P 500 ETF (IVV) have amassed billions of dollars in investments, the S&P 500 was originally launched as a yardstick of performance rather than an investment vehicle.
A New Twist
In the 1990s, major index providers began offering equal weighted versions of their indexes. Not long thereafter, on April 24, 2003, the Guggenheim S&P 500 Equal Weight ETF (RSP)—the industry’s first equal weight ETF—made its debut.
Instead of favoring the largest stocks within the S&P 500, the equal weight index (EWI) version gives all 500 stocks an equal 0.20% weighting. “It’s designed to be size neutral” is how Standard & Poor’s describes the S&P 500 EWI’s character. What type of impact would this equal weight twist have on performance?
Over the past decade, RSP has gained 143% compared to a gain of just 117.84% for SPY. Why is the margin of outperformance over the traditional S&P 500 so large? As research from Fama-French has shown, smaller stocks— which the S&P 500 EWI favors—carry higher risk with higher expected returns.
What about volatility? The 10-year trailing standard deviation for the S&P 500 EWI was 17.54 compared to 14.76 for the S&P 500, according to Morningstar. Although equal weighted indexing comes with higher volatility, long-term investors have been rewarded with outperformance.
Equal Weight Challenges
Excessive portfolio turnover remains one of the key hurdles facing equal weighted indices. These types of indices need to be regularly rebalanced to counteract daily price changes of stocks in order to maintain equivalent market exposure. And that creates frictional trading costs and index tracking error.
