Howard Gold's No-Nonsense Investing: Long-term investors can beat the S&P 500 by favoring equal-weighted ETFs

Mutual Funds


On Monday, S&P Dow Jones Indices and MSCI reshuffled their sector lineup.

They replaced the stodgy, underperforming telecom services sector with a new, expanded communications services sector that now includes stocks that were previously in the information technology and consumer discretionary sectors, such as Alphabet

GOOG, +0.96%

GOOGL, +1.21%

Facebook

FB, -0.30%

Netflix

NFLX, -0.05%

and Walt Disney

DIS, +0.76%

(Amazon

AMZN, +2.08%

 will stay put among consumer discretionary stocks.)

The total weighting of the technology and consumer discretionary sectors in the S&P 500 Index

SPX, -0.13%

 will shrink as both lose some heavy hitters. Apple will make up 20% of the tech sector, up from 16% before, making technology more dependent on that single stock.

So if, like most of us, you’re an index investor, how do you reduce the risk of owning one big individual stock, even if it has been a great one, like Apple? Indexes are supposed to provide that diversification, but in a market-cap-weighted index such the S&P, one or two stocks that have racked up big gains can become a disproportionate share of your holdings.

Equally weighted index ETFs solve that problem. Since they hold an equal amount of every stock in a sector or index, they rebalance regularly (usually every quarter) by selling off the excess gains of the winning stocks and buying enough of the losers to maintain the portfolio’s equal weighting. Equal weighting is part of “factor” or “smart beta” investing, in which investors identify what BlackRock calls “broad, historically persistent drivers of return” to produce better risk-adjusted performance than traditional, market-cap-weighted indexes.

OK, enough jargon. Does it work?

It does — and much better than I expected, though I have owned and recommended equal-weight ETFs for years. I crunched a whole bunch of numbers — yes, I’m one of those geeky types who enjoys stuff like that — and found that over longer holding periods, equal-weight ETFs outperform not only the S&P but also most regular sector funds, often by a lot.

Yet this strategy has hardly been “discovered”: U.S. equal-weight ETFs had total net assets of $46.6 billion as of August, only 1.25% of the $3.7 trillion invested in all U.S.-domiciled ETFs, according to Morningstar Direct.

The table below tells the story. I selected the four best-performing sectors of the past 10 years, compared the standard ETFs (Sector SPDRs) with their equivalent Invesco equal-weight ETFs (Invesco bought Guggenheim Securities’ ETF business, including its equal-weight ETFs, earlier this year), and threw in two S&P 500 index ETFs for comparison.

ETF Ticker Total return – 2018 through Sept. 20 Average annual return – 10 years
Invesco S&P 500 Equal-Weight Technology ETF

RYT, -0.41%

18.9% 15.1%
Technology Select Sector SPDR ETF 

XLK, -0.12%

17.6% 13.5%
Invesco S&P 500 Equal-Weight Health Care ETF

RYH, -0.05%

12.4% 14.5%
Health Care Select Sector SPDR ETF 

XLV, -0.31%

14.4% 11.7%
Invesco S&P 500 Equal-Weight Cons. Discretionary ETF

RCD, -0.22%

 

7.2% 13.0%
Consumer Discretionary Select Sector SPDR ETF 

XLY, +0.42%

19.3% 11.5%
Invesco S&P 500 Equal-Weight Industrials ETF

RGI, -0.33%

4.5% 10.8%
Industrial Select Sector SPDR ETF 

XLI, -0.31%

5.6% 9.1%
Invesco S&P 500 Equal-Weight ETF

RSP, -0.27%

7.0% 11.4%
SPDR S&P 500 ETF 

SPY, -0.09%

10.1% 8.9%
Returns are based on net asset values (NAV). Sources: Invesco, State Street Global Advisors.

As you can see, for 10 years ended Sept. 20, the equal-weight ETFs in technology, health care, consumer discretionary, and industrials had 10-year compound annual gains that beat their Sector SPDR equivalents by 1.5-2.8 percentage points a year. Over time, this can be a very big deal, especially because it is net of fees: The Invesco equal weight sector funds’ expense ratio is 0.4% of assets, triple the Sector SPDRs’ 0.13% a year.

Equal-weight ETFs also beat their SPDR counterparts over the last 10 years in the sectors not displayed on the table — consumer staples, energy, financials, materials, and utilities — often by wide margins.

A simple equal-weight S&P 500 ETF also topped the SPDR S&P 500 ETF

SPY, -0.09%

by 2.5 percentage points a year over the last 10 years.

Why does this strategy work? Nick Kalivas, senior equity ETF product specialist at Invesco, told me that equal-weight ETF investing “tends to tilt toward smaller companies relative to market cap because of the equal weighting. You [also] have a bit of a value tilt, because essentially those stocks aren’t rising as much.” Academic research has long found that smaller and value-oriented stocks produce superior returns over time.

But with equal-weight ETFs, there is “kind of an anti-momentum dynamic that is present because every quarter you’re kind of cutting back what has risen a lot and adding to what has lagged,” he added. “The trouble with market-cap-weighted [indices] longer term is you ride the momentum up. But there is no mechanism to kick those stocks out again. So, you ride them down.”

That is why standard indexes may outperform equal-weight ETFs in the short run, as they have done so far in 2018. But over time that evens out, and then some.

For long-term investors, that is all that really matters.

Howard R. Gold is a MarketWatch columnist and founder and editor of GoldenEgg Investing, which offers exclusive market commentary and simple, low-cost, low-risk retirement investing plans. Follow him on Twitter @howardrgold.

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