Equal Weighting Works For This Industry ETF

Among sector and industry exchange traded funds, few if any have turned performances over the past several years that can rival the legendary showings by biotechnology ETFs. Consider this: Each of the five oldest biotech ETFs currently on the market have easily more than doubled over the past three years.

Said another way, it has been hard to go wrong with biotech ETFs in recent years. With the benefit of hindsight, it is clear that equal weighting, perhaps thegodfather of strategic beta ETFs, has proven particularly efficacious when it comes to biotech ETFs. The SPDR S&P Biotech ETF (NYSE:XBI), the third-largest biotech ETF by assets, proves as much.

The $2.28 billion XBI is equally weights its 103 holdings and the results have been stellar. Over the past three years, XBI has surged 153.2 percent, topping the next closest biotech ETF by 300 basis points. As has been proven with other equal-weight ETFs, there are benefits to the methodology to which XBI adheres.

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One of those benefits is less skew to its top holdings. For example, XBI's top 10 holdings combine for less than 14 percent of the ETF's weight, according to issuer data, while some capitalization-weighted biotech ETFs devote close to 60 percent of their combined weights to their top 10 holdings.

"As market cap-weighted indices assign the largest weights to those securities with the greatest market values, it stands to reason that these indices would exhibit an inherent large-cap bias," said State Street Global Advisors Vice President Dave Mazza ina recent note.

However, XBI's advantages do not imply a free lunch. A hallmark of many equal-weight ETFs is a tilt toward smaller stocks not present in cap-weighted funds. XBI's holdings have a weighted average market capitalization of $9.8 billion. As a result although XBI has been the best-performing biotech ETF over the past three years, it has also been the most volatile.

Still, investors willing to embrace that risk have been rewarded as XBI has been intimately levered to the catalysts driving biotech stocks higher, including a favorable FDA environment and plenty of mergers and acquisitions.

"We've discussed the strategic benefits of equal-weighted indices, and they have tactical benefits as well. For instance, as a result of deeper market cap segmentation and industry breadth, XBI has been able to better capture a prevalent trend within Biotech: mergers and acquisitions. XBI, relative to IBB, has overweighted M&A targets in most of the top deals over the last 18 months. In fact, XBI has been overweight in 11 out of the top 12 deals, while IBB did not hold a position in 2 of those deals," adds Mazza.

IBB refers to the iShares Nasdaq Biotechnology ETF (NASDAQ:IBB).

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