As investors have become more acquainted with exchange-traded products, some have wondered why so many broader market and sector funds are dominated by the largest companies. As Apple (AAPL) has shown investors, an ETF's excessive allocation to just one or two stocks is fine on the way, but rather dangerous on the way down.
The reason why the companies with largest market values loom large in so many ETFs is simple: Many ETFs use a cap-weighted methodology to assign weights to the components. For example, a cap-weighted ETF focused on U.S.-based energy producers would, more than likely, have Exxon Mobil (XOM) as its largest component, Chevron (CVX) as its second-largest and so on.
There are alternatives to cap-weighting, namely in the form of equal-weight ETFs. The concept behind equal-weight equity-based ETFs is a compelling one. After all, one of the allures of ETFs is gaining exposure to multiple stocks through one fund and no one likes the nasty surprise of finding out their ETF is excessively weighted to just one or two stocks.
Some equal-weight ETFs have risen to acclaim over the years for outperforming their cap-weighted counterparts over long time horizons. Some toil in anonymity. Here is a look at a few of the more anonymous equal-weight ETFs that have the potential to deliver solid returns.
First Trust NASDAQ-100 Equal Weighted Index Fund (QQEW) Depending on one's view of Apple, QQEW is either an afterthought or the perfect tech ETF for the times. Apple, the world's largest company by market value, accounts for a scant 0.91 percent of QQEW. That means the iPad maker is 35 basis points "less important" to this ETF than Netflix (NFLX), the fund's largest holding.
These days, that is not a bad thing. As Apple has tumbled, QQEW has shown its mettle. In the past month, shares of Apple have plunged 9.5 percent, dragging the PowerShares QQQ (QQQ) to a loss of 4.7 percent in the process. Over the same period, QQQEW is off just 3.1 percent.
Given Apple's large weight in QQQ, currently 18.9 percent, the premise here is simple. QQEW offers protection from downside in that stock while keeping investors exposed to the tech sector. Also consider the Direxion NASDAQ 100 Equal Weighted Shares (QQQE).
SPDR S&P Health Care Equipment ETF (XHE) Some folks may not realize that the SPDR sector funds, not the select sector SPDRs such as the Technology Select Sector SPDR (XLK), are actually equal-weight products. They are not perfect in terms of equal weights, meaning XHE does not have 100 components each accounting for one percent.
Rather, XHE has 58 holdings and the largest receives a weight of 2.89 percent. XHE's approach is working. Year-to-date, the ETF has outperformed its primary rival, the iShares Dow Jones U.S. Medical Devices Index Fund (IHI), by 150 basis points.
Guggenheim S&P 500 Equal Weight Health Care ETF (RYH) RYH will celebrate its sixth birthday on Thursday, but the fund has just $53.9 million in assets under management, indicating that investors have not yet taken note of the utility of this ETF. Where RYH stands out is at the sub-sector level where it spreads about 78 percent of its weight between health care services providers, equipment makers and traditional pharmaceuticals names.
While RYH does not track the same index as XLV, the two are bound to draw comparisons to each other. XLV, the largest health care ETF with $5.4 billion in assets, is up 16.2 percent this year. That is only marginally better than RYH and RYH could easily be viewed as the more attractive option because of its equal status.
Figure it this way. If Johnson & Johnson (JNJ), Pfizer (PFE) and Merck (MRK) combined for 34 percent of XLV's weight. Those stocks are intimately correlated to each other, implying investors do not have to worry about single-stock risk with XLV. They have to be concerned with potential three-stock (maybe more) risk with this ETF.
Considering that pharmaceuticals stocks are performing well this year, it would be reasonable to expect RYH would be lagging an ETF like XLV by a wider margin. That has not been the case and that makes RYH all the more attractive.
For more on equal-weight ETFs, click here.
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