Market indexes come in two flavors: capitalization-weighted, in which the stocks with the greatest market value carry considerably more weight than smaller ones, and equal-weighted, in which all stocks -- regardless of market cap -- have an equal impact on index performance.
Index managers have long preferred cap weighting because it's easier to maintain: Changing market values are reflected in each stock's market cap, and thus the index essentially rebalances itself. In an equal-weighted index, the manager has to make continuous portfolio adjustments to keep the components in equal proportion. As a result, the Standard & Poor's 500 index, along with other major market indexes, has always been cap weighted.
Still, to many investors equal-weighted indexes offer a definite appeal -- a relatively greater exposure to small-cap stocks or shares that may offer outstanding value. To satisfy that demand, in December Rockville, Marylandbased Rydex Global Advisors filed a request with the Securities and Exchange Commission to create the first equal-weighted S&P 500 exchange-traded fund. ETFs are passively managed mutual funds that trade on stock exchanges.
"This will give institutional investors a complementary way to hedge their bets," explains Robert Steele, head of product development at Rydex. "Investors get a proxy for the equity market, only with more value exposure, more small-cap exposure and less technology." The new fund would be the first ETF for Rydex, a mostly quantitative equity shop that manages $6 billion in 34 mutual funds.
"An equal-weighted ETF is a significant innovation," says Jing Sun, an analyst at Boston-based consulting firm Financial Research Corp.
Large institutions have increasingly used ETFs in lieu of futures to hedge positions or maintain equity exposure while parking large amounts of cash. ETFs offer real-time market pricing and impose no obligation to mark a derivative instrument to market. More and more brokers and registered investment advisers are using the funds to build model portfolios. There are now more than 100 ETFs, the largest of which are the S&P 500 Spdr and QQQ, known as cubes, which tracks the Nasdaq 100 index.
"The equal-weighting structure should be able to draw some attention -- smaller stocks have outperformed large stocks for nearly three years," says FRC's Sun. "By giving more weight to smaller companies, the new ETF could be more appealing than market-weighted Spdrs or IShares [ETFs that mimic market indexes]."
According to Leuthold/Weeden Research, a Minneapolis-based brokerage and money manager, an equal-weighted portfolio of S&P 500 stocks has outperformed its cap-weighted counterpart in 60 percent of the years since 1957, when the index was introduced in its present form.
But, Sun says, if the market turns around and large-cap stocks do well, an equal-weighted index will underperform. "Smaller stocks tend to be less liquid and the trading costs correspondingly higher," she says.
When Wells Fargo & Co. launched the first S&P 500 index vehicle in the early 1970s, it was equal-weighted. Because the index required daily rebalancing, it was very difficult and expensive to manage. But Ludwig Chincarini, head of equity research at Rydex, says that his firm is sacrificing some performance accuracy and will only rebalance the ETF quarterly. As a result, it won't be nearly as cumbersome as some of its equal-weighted predecessors. Every three months positions in stocks that went up will be trimmed and funneled back into the stocks that flatlined or dipped.
Standard & Poor's has granted Rydex a license -- and a vote of confidence. "Cap weighting is still the method of choice," says Rydex's Steele, "but the S&P sees the complementary aspects of equal weighting."