What Makes This Equal-Weight ETF Tick

Weighting stocks equally is one of the oldest alternatives to weighting by market capitalization in the world of index funds and exchange traded funds. The methodology has proven popular with advisors and investors looking to avoid concentration risk and tap the advantages of the size factor.

The Invesco S&P 500 Equal Weight ETF RSP has a track record that spans more than 15 years and has nearly $15 billion in assets under management.

What Happened

RSP has a long history of outperforming cap-weighted S&P 500 funds. From 2012 through 2017, RSP topped cap-weighted rivals in four of those six years. Since inception in April 2003 through the end of 2017, RSP gained 386.2 percent compared to 292 percent for the largest cap-weighted S&P 500 ETF.

RSP's methodology “increases the fund's exposure to the smaller and riskier stocks in the S&P 500,” said Morningstar in a note out Friday. “Equal-weighting diversifies firm-specific risk but leads to persistent sector bets that may not always pay off. The fund's low fee offers a durable cost advantage, but there are market-cap-weighted mid-cap stock funds available for a fraction of the fee.”

Why It's Important

One of the aims of equal-weight funds is to reduce sector concentration and single stock risk. None of RSP's 505 holdings garner weights of 0.28 percent and the fund's top 10 holdings have a combined weight of just 2.81 percent. In the cap-weighted S&P 500, Apple Inc. AAPL on its own accounts for 4.03 percent of the benchmark.

The average market capitalization of RSP's components is just under $49 billion where the average market value of the cap-weighted S&P 500 members is nearly $231 billion. Wide differences in components' market value aren't uncommon between cap-weighted and equal-weight ETFs. Many market observers believe the ability of equal-weight funds, like RSP, to generate alpha revolves around the size factor.

“This approach increases the fund's risk, and its performance since inception in May 2003 has more closely matched mid-cap rather than large-cap stock index funds,” according to Morningstar.

What's Next

Another thesis holds that equal-weight strategies benefit from a tilt toward value stocks. RSP has some of that tilt as large- and mid-cap value stocks combine for almost 37 percent of the fund's weight. Growth stocks represent 27 percent of RSP's roster. There's some added risk with RSP and there are no guarantees that risk will always pay off.

“Its risk-adjusted returns (as measured by its Sharpe ratio) landed near the 33rd percentile. The fund's higher risk has paid off, but that won't always be the case. For example, during the bear market from October 2007 through March 2009, this fund cumulatively lost 59.1% of its value compared with 55.0% for the S&P 500,” according to Morningstar.

The research firm has a Bronze rating on RSP.

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