Thursday, September 2, 2010

Equally weighted ETFs

Most index ETF’s bought by investors today, including SPY, QQQ, FTSE 100, ISEQ 20, are market-capitalization weighted. A company's weight in an ETF is determined by its total market capitalization, or the share price multiplied by total shares outstanding. Therefore, the returns of large-cap stocks in the index play a much greater role in the overall index performance than small caps. When large-caps are Performing their dominance is overwhelming and can mask the overall health of the ETF. And the opposite is also true (eg BP).

While and Equal weighted Index ETF is just as it sounds. Every stock in the index has the same weight, regardless how large or small the company is. So in the S&P 500 equally weighted portfolio Microsoft will have an equal weighting with Paychex Inc.

1. Kenneth French from Dartmouth's Tuck School and the University of Chicago's Eugene Fama, have shown that small cap outperformed other securities over most significant historical periods, so an equal weighted ETF sould take advantage of this finding and should produce larger returns. (link to academic paper)

2. In an equal weighting ETF when rebalancing you are essentially selling your winners and buying loosers. So it’s a play on the market reverting to the mean. mean reversion refers to the tendency of extreme performers, (either high or low), in one period to perform the opposite in the future.( for more on mean reversion)


1. For equal weighting, large transaction are incurred for the constant re-weighting back to the original equal dollar amounts, (From 2002 to 2008, the amount of average annual turnover for the Equally Wweighed version of the S&P500 was about 22%, versus 4% for Index.

But we can use the Equal weighting as a proxy for the health of the Cap weighted EFT.

I'll have a look of I can get some get the correct data to come try and test this hypothesis.

Fundamentally weighted Indexes could provide better returns? Intresting
Chart of SPY vs RSP.

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