Investing in an S&P Equal Weight ETF
T he S&P 500 is known for being top-heavy. Big-name companies like Amazon, Apple, and Facebook account for a huge chunk of the total weight of the index.
While many investors consider the S&P 500 to be at the top of the list of large-cap index funds you can buy, you might balk at the fact that the index is incredibly concentrated (especially in terms of tech stocks). You take a risk by buying into indexes that have a high concentration of high-priced stocks like this. However, equal weight ETFs help avoid this problem while still offering exposure to the stocks included in the S&P 500.
- The S&P 500 Equal Weight Index was created as a way to give investors an equal-weight method of investing in companies and sectors included in the traditional market capitalization-weighted S&P 500 index.
- Equal weight ETFs give every included stock equal weight, no matter how big or small a given company is. This differs from market value-weighted funds, which can get overwhelmed by one or two stocks that perform well.
- Equal weight ETFs rebalance on a regular basis to retain equal division among all their components.
- Equal weighted ETFs offer an intriguing investment opportunity for long-term investors, thanks to their inherent diversification.
What Is the S&P Equal Weight ETF?
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The S&P 500 Equal Weight Index, or EWI, was created in January 2003 to give investors an equal-weight option to the popular S&P 500 Index. The same stocks make up both indexes. However, different weighting structures mean the EWI version has different properties and offers different benefits to investors.
The S&P 500 is a stock market index. It measures the performance of around 500 United States-based companies. The index includes companies in 11 sectors in order to give investors a snapshot of the U.S. stock market and the broader economy.
S&P 500 Market Weight ETFs vs. S&P 500 Equal Weight ETFs
To better understand what an S&P Equal Weight ETF really does, let’s explore both market weight ETFs and equal weight ETFs.
Imagine the S&P 500 as a pie (or pie chart). A market weight ETF breaks that S&P 500 pie into slices determined by the market cap. On the other hand, an equal weight ETF means that all of the slices are the same size, no matter how big or small a sector or company is.
S&P 500 Market Weight ETFs
Like many other stock market indexes, the S&P 500 is an index weighted by market capitalization. You can determine the market capitalization of each stock by multiplying the share price of that stock by the number of outstanding shares. Companies that have the greatest values due to the largest market capitalizations will also have the highest weight in that index.
Many companies comprise the S&P 500 index. However, the sector weight of a market value-weighted index, or MWI, is calculated as the sum of individual weights of companies that make up a given sector. The weight of any company in the index equals that company’s market cap divided by the total market cap of every company in that index.
S&P 500 Equal Weight ETFs
Once you know what a market-weighted index is, you’ll see that an equal-weighted index is pretty much what it sounds like. Every stock in that index has an equal weight. That weight is the same no matter how small or big a given company is. In other words, an industry giant like Apple ends up having the exact same weight that the smallest company in the S&P 500 has.
When it comes to equal weight indexes, sector weight is truly a direct function of the number of companies that exist in a sector. If a sector has 50 stocks, for instance, the weight of the sector, in theory, will be 10% (or 50 / 500 x 100).
Key Differences to Consider When Investing
A few key differences between market and equal weight ETFs exist, including:
- Balancing and adjusting needs: While both the normal market weight ETFs and the equal weight ETFs need to be adjusted periodically, the equal weight ETFs must also be rebalanced. You do not need to rebalance market-weighted ETFs.
- Sector exposures: Because the S&P 500 and S&P 500 EWI have different weighting schemes, this will create different sector exposures.
- Volatility: Generally, volatility is higher on the S&P 500 EWI than on the S&P 500. This happens because small-cap stocks tend to be more volatile than bigger companies. As the S&P 500 EWI tilts more toward small-cap stocks than the S&P 500, it creates higher volatility on the EWI.
You can trade ETFs that represent both the equal weight index and the traditional index. However, even if two kinds of ETFs have the same basket of companies, that does not mean they will perform similarly at all.
Advantages and Disadvantages of Equal Weight ETFs
If you’re an index investor, owning one big individual stock comes with considerable risk. The point of indexes is that they get you diversification. However, indexes weighted by market caps (like the S&P 500) can mean that a couple of stocks that make big gains can turn into a disproportionate share of an investor’s holdings. Even if those stocks are generally great, it creates risks for the investor because the inherent benefit of diversification is reduced.
You can mitigate that problem by investing in index ETFs that are equally weighted. Advantages of equal weight ETFs include:
- Better risk-adjusted performance: S&P equal weight ETFs may perform better when adjusted for risk than their traditional counterparts that are weighted by market cap.
- Increased diversification: Instead of being concentrated into the largest companies in an index, equal weight ETFs are much more diversified.
- Increased protections: Equal weight ETFs offer investors more protections in case a large sector goes on a downturn. Because there’s equal weighting, small sectors that are underperforming can offset losses more than they could with a market weight ETF. You’ll thus reduce your exposure to steep declines.
- Long-term gains: Equal weight ETFs go against momentum because they’re constantly rebalancing. While you can ride momentum up with market cap weighted indexes and make significant short-term gains, you have no way of getting those stocks out when they take a downturn — and you end up going along with that momentum down again. That why equal weight ETFs tend to be a good choice for long-term investors.
- Natural value-approach: If you’re an investor that looks for a value-approach, equal weight ETFs naturally provide that.
- Regular rebalancing: Because equal weight ETFs have an equal amount of every stock in a given index or sector, they rebalance on a regular basis (typically each quarter). They do this by selling excess gain of winning stocks and purchasing enough of the losing stocks to maintain the equal weighting of the portfolio.
Equal weight ETFs also have a few disadvantages, including:
- High turnover: Because equal weight ETFs tend to have a higher turnover than market cap counterparts, you’ll have to contend with higher expense ratios and higher capital gains taxes.
- High volatility: Again, equal weight ETFs are more volatile than market weight ETFs. That makes them more apt to fall sharply during a recession.
- Potential for sector underperformance: Sectors that have high catastrophic loss rates (such as information technology) can be more likely to underperform in funds with equal weighting.
Finding an S&P Equal Weight ETF to Invest In
You’ll find different ways to invest in equal weight ETFs that focus on various industries. Here are a few to check out when you’re ready to start investing. Keep in mind that these are just options to consider, and we are not making any recommendations.
- Invesco S&P 500 Equal Weight ETF (RSP): This ETF offers an intriguing opportunity for risk-averse investors. By targeting even allocation in each of the S&P 500’s stocks, this ETF avoids heavy concentration on any single area of the market and thus provides even more diversification than other investing possibilities. The diversified approach also allows the fund to avoid volatility that can affectfunds benchmarked to an S&P index that’s market weighted.
- SPDR S&P Bank ETF (KBE): This ETF of approximately $1 billion spreads investments evenly throughout the financial sector. This allows the fund to stay away from relying on bigger Wall Street banks. The ETF instead goes for allocations lower than 2% in all of its 86 components. By ensuring that small, regional stocks included in the fund have the same effect as bigger banks, KBE reduces volatility and adds diversification.
- SPDR S&P Biotech ETF (XBI): This ETF tracks the S&P Biotechnology Select Industry Index. The Index holds small-, mid-, and large-cap stocks in the biotech sector. It’s a relatively affordable option that finds stability thanks to its huge sum of assets and high daily trading volume.
- SPDR S&P Aerospace & Defense ETF (XAR): Like tech, the aerospace and defense sector can populate ETFs with a small number of huge stocks. This ETF ensures that the typical industry giants don’t overshadow small stocks.
B y investing in an S&P equal weight ETF, you’ll get more protection if a sector experiences a downturn. This investment strategy can work well for investors with a long-term outlook.