The Truth About Alter­na­tive Weight­ing Method­olo­gies (And ETFs)

by Michael John­ston , ETFdb on Feb­ru­ary 7, 2012 | Secu­ri­ties Men­tioned: AAPL • F • RSP • SPY

As indexes have been essen­tially trans­formed into investable assets in part because of surg­ing inter­est in ETFs, many advi­sors and investors have begun to take a closer look at the details of the method­olo­gies behind the con­struc­tion and main­te­nance of these bench­marks. Cap weight­ing, where the largest weights are afforded to the largest com­pa­nies, has remained by far the most pop­u­lar option–thanks in no small part to the low costs and low main­te­nance require­ments asso­ci­ated with this approach. But alter­na­tive weight­ing strate­gies have been grow­ing in pop­u­lar­ity as well, emerg­ing as oppor­tu­ni­ties to gen­er­ate excess returns by sim­ply tweak­ing the man­ner in which weights are assigned to indi­vid­ual secu­ri­ties [see also The Ten Com­mand­ments of Com­mod­ity Invest­ing].

There has been a sig­nif­i­cant amount of debate on the mer­its of these weight­ing method­olo­gies, includ­ing at a panel last month at the Inside ETFs Con­fer­ence pre­sented by Index Uni­verse. Many view the alter­na­tive weight­ing method­olo­gies (mean­ing any­thing that is not mar­ket cap weight­ing) as sim­ply a bet­ter way to index, thanks to the abil­ity to break the link between stock price and secu­rity allo­ca­tion. There is another school of thought that the var­i­ous alter­na­tive weight­ing method­olo­gies out there are sim­ply ways of tilt­ing expo­sure towards var­i­ous “fac­tors” such as value or lever­age. Below, we run through some of the pop­u­lar alter­na­tive weight­ing method­olo­gies out there from a dif­fer­ent per­spec­tive: the tilts that result from the nuances of the under­ly­ing strat­egy [for more ETF insights, sign up for the free ETFdb newslet­ter].

Equal Weight = Small Cap

Equal weight­ing method­olo­gies have drawn increased inter­est in recent years, thanks in part to the impres­sive per­for­mance of the Rydex S&P Equal Weights ETF (RSP) rel­a­tive to the S&P 500 SPDR (SPY). Though both ETFs hold the same 500 stocks, RSP has fared much bet­ter for the last sev­eral years.

The appeal of RSP lies in the oppor­tu­nity to break the link between weight and stock price, thereby avoid­ing what some argue is an embed­ded inef­fi­ciency in this method­ol­ogy. But there is another way to think of equal weight­ing: as a shift towards smaller com­pa­nies. RSP, for exam­ple, has a con­sid­er­ably larger allo­ca­tion to mid cap stocks than does SPY, since the weight­ings to the stocks with the largest mar­ket caps are lim­ited. The focus on smaller com­pa­nies gen­er­ally means greater volatil­ity on both the up side and down side; that rela­tion­ship has cer­tainly played out between RSP and SPY [see also RSP vs. SPY: 2011 At a Glance].

Equal weight­ing can also be thought of as hav­ing a con­trar­ian or anti-momentum tilt, since allo­ca­tions are brought back to the “base weight” upon rebal­anc­ing. That effec­tively means that weight­ings in the best per­form­ers are reduced, with the pro­ceeds used to pur­chase shares of stocks that have strug­gled recently.

Div­i­dend Weight = Value Stocks

Div­i­dend weighted ETFs have also seen increased inter­est over the last year, emerg­ing as one effec­tive tool for investors look­ing to enhance cur­rent returns and reduce risk. Div­i­dend weight­ing can also be thought of as a way of imple­ment­ing a value tilt, since this approach will gen­er­ally result in a larger weight­ing to value stocks than a cap-weighted approach. Growth com­pa­nies that are rein­vest­ing cap­i­tal will be given a rel­a­tively small weight com­pared to stocks that make hefty pay­outs. So it shouldn’t be sur­pris­ing that dividend-weighted ETFs will per­form well when value stocks are out­per­form­ing but may strug­gle in envi­ron­ments where growth stocks have the edge [see Div­i­dend ETF Spe­cial: 25 ETFs With Juicy Yields].

It should also be noted that dividend-weighted indexes (as well as div­i­dend yield-weighted indexes) will exclude stocks that do not make dis­tri­b­u­tions. In some cases, that means miss­ing out on impres­sive returns; AAPL, which has sky­rock­eted in recent years, won’t be found in any dividend-weighted ETF [see also 12 High-Yielding Com­modi­ties For 2012].

Rev­enue Weight = Low Mar­gin, High Debt Companies

While the tilts deliv­ered by the weight­ing approaches high­lighted above may be rather obvi­ous, the ram­i­fi­ca­tions of rev­enue weighting–where allo­ca­tions are deter­mined by top line sales–may not be so clear. Rel­a­tive to cap weight­ing, this method­ol­ogy will tend to over­weight stocks with thin profit mar­gins (as well as those oper­at­ing at a loss), since higher earn­ings (which gen­er­ally lead to a higher mar­ket cap) have no impact on weight­ing method­ol­ogy. This explains in part why Ford Motor Com­pany (F) is the fifth largest hold­ing of the Rev­enue­Shares Large Cap Fund (RWL) at 1.5% of assets, while the car­maker accounts for just 0.4% of SPY (and is not even in the top 50).

Rev­enue weight­ing also tends to intro­duce a shift toward com­pa­nies with higher debt-to-equity ratios, since the impact of inter­est expense is non-existent–only top line rev­enue mat­ters. Because the equity value (i.e., mar­ket cap) can be cal­cu­lated by deduct­ing debt from over­all enter­prise value, cap weighted bench­marks would gen­er­ally give higher weight­ings towards a com­pany with low debt, all else being equal. Rev­enue weight­ing shifts expo­sure towards com­pa­nies with higher lever­age, which can result in strong per­for­mances in bull mar­kets but cause prob­lems when mar­kets fall [see also Three Rea­sons Why Gold Is Over­val­ued].

RAFI Weight = Value Stocks

The RAFI method­ol­ogy devel­oped by Research Affil­i­ates has become quite pop­u­lar in recent years, and the com­pany has teamed up with mul­ti­ple ETF issuers to develop prod­ucts that uti­lize this approach to secu­rity weight­ing. Rather than rely­ing on one fun­da­men­tal fac­tor, RAFI weight­ing uses four: book value, cash flow, sales, and dividends. While many view RAFI indexes as an enhanced beta, it’s also rea­son­able to see this strat­egy as another way of tilt­ing expo­sure towards value stocks and low mar­gin com­pa­nies, since this approach incor­po­rates two of the fac­tors out­lined above [see Do You Need A RAFI ETF?].

The More The Merrier

Ulti­mately, there is no uni­ver­sally supe­rior weight­ing method­ol­ogy that holds the secret to excess returns. Cap weight­ing will per­form well in cer­tain envi­ron­ments, while equal weight­ing will lead the way in oth­ers. The same can be said for all the other strate­gies out there; dividend-weighted ETFs enjoyed a ban­ner 2011 as inter­est in stocks offer­ing mean­ing­ful cur­rent returns surged.

The choice of weight­ing method­ol­ogy is a very impor­tant one that has the poten­tial to have a major impact on bot­tom line returns. But keep in mind that weight­ing method­olo­gies essen­tially reflect a tilt towards one fac­tor another, whether it be small cap stocks, value stocks, or lever­aged stocks. There are envi­ron­ments in which each of those method­olo­gies will per­form well, and oth­ers in which they will strug­gle [see also ETFs For The Cap­i­tal Preser­va­tion­ist].

Dis­clo­sure: No posi­tions at time of writing.

ETF Data­base is not an invest­ment advi­sor, and any con­tent pub­lished by ETF Data­base does not con­sti­tute indi­vid­ual invest­ment advice. The opin­ions offered herein are not per­son­al­ized rec­om­men­da­tions to buy, sell or hold secu­ri­ties. From time to time, issuers of exchange-traded prod­ucts men­tioned herein may place paid adver­tise­ments with ETF Data­base. All con­tent on ETF Data­base is pro­duced inde­pen­dently of any adver­tis­ing rela­tion­ships. Read the full dis­claimer here.

Read more from the author/contributor here.

Comments

Comments are closed.