Alternative Weighted ETFs Can Boost Gains

Trend: A S&P 500 index equal weighted ETF (RSP, +29% YTD) has almost doubled the performance of the giant traditional cap-weighted ETF (SPY, +15% YTD) in 2009.

Ron Rowland at Money and Markets provides an excellent overview of the weighting options available to ETF investors. Excerpts below.

Link: Get Creative With Alternative Weighting ETFs | Money and Markets

Weighting is simply the way stocks are distributed in a portfolio. An index is nothing more than a publicly-available list of stocks that are weighted according to some sort of strategy. The S&P 500, for example, consists of 500 large U.S. stocks that are selected by a committee at Standard & Poor’s. Like most indexes, the S&P 500 is “cap-weighted.” Each stock receives an allocation equal to its proportional market capitalization — the total value of all outstanding shares at the latest price.

With hundreds of stocks in the index, it’s obvious that a few large companies dominate the portfolio. The remaining ones get very small allocations — a fraction of a percent in most cases.

This is the drawback to cap-weighted indexing: The bigger companies get an outsize share. That’s great if those companies perform well, but not so great if they run into trouble.

To address this problem — and hopefully attract investors — some ETF sponsors have developed alternative weighting schemes. None are perfect, of course, but they can be very useful at times.

Equal Weighting

This approach is strikingly simple: Just divide the money between all the stocks in an index equally. If your index consists of 50 stocks, each one gets 2 percent.

Equal weighting was pioneered by Rydex, which offers a series of ETFs using this methodology. Rydex S&P Equal Weight ETF (RSP) owns the same stocks as the S&P 500 but with equal-weighting rather than cap-weighting.

The smaller-cap stocks get a bigger weighting in RSP than they do in SPY. And those stocks have done generally better this year than most of the mega-cap issues. This isn’t always the case. But equal weighting clearly had a huge positive impact so far this year.

In addition to RSP, here are some other equal-weighted ETFs you might want to consider:

• SPDR S&P Biotech ETF (XBI)
• First Trust Nasdaq-100 Equal Weighted Fund (QQEW)
• SPDR S&P Semiconductor ETF (XSD)

Dividend and Earnings Weighting

If you love income, then you’ll probably want to tilt your portfolio toward the stocks with a record of growing their dividends. So take a look at the ETFs offered by WisdomTree.

WisdomTree argues that, by design, cap-weighted ETFs are forced to buy high and sell low. Here’s why that’s true:

The higher a stock’s market capitalization (shares outstanding multiplied by the share price), the more shares a cap-weighted ETF buys. If those share prices decline, the market capitalization of the stock declines as well. Consequently, they are replaced with higher-cap stocks when the ETF rebalances its portfolio.

WisdomTree’s solution is a set of indexes that use fundamental factors like dividends and earnings to allocate among stocks. They think this will lead to better long-term results, and they have a lot of research to support their point.

One advantage of this approach is that dividends and earnings are much more objective than stock prices as a way of measuring a company’s success. We’ve all seen stocks launched into orbit by irrational investors chasing surging stock prices, only to come crashing back down.

Dividends aren’t so easily manipulated. And screening for companies with consistent earnings can help weed out the money-losing and speculative ones.

WisdomTree has a whole family of ETFs that follow variations on this theme. Some of the most popular are:

• WisdomTree Dividend excluding Financials (DTN)
• WisdomTree India Earnings Fund (EPI)
• WisdomTree Emerging Markets SmallCap Dividend (DGS)

Revenue Weighting

Another methodology is offered by a company called RevenueShares. The name gives away their strategy: Stocks in their ETFs are weighted by revenue.

Revenue is even more resistant to manipulation than earnings. In accounting lingo, it’s the “top line” of money coming in. Public companies are required to disclose it in their SEC filings, so the information is readily available.

RevenueShares says that weighting stocks by their revenue can deliver attractive returns over time. Though of course it doesn’t mean their strategy will work all the time. Here are some of the best-known RevenueShares ETFs:

• RevenueShares Small Cap (RWJ)
• RevenueShares Mid Cap (RWK)
• RevenueShares Large Cap (RWL)

Combinations of Fundamental Weightings

Rob Arnott, of Research Affiliates, has created fundamentally weighted indexes using a combination of factors such as sales, book value, dividends, and cash flow. And he has teamed up with FTSE to offer the FTSE-RAFI indexes.

Some of the ETFs using this approach include:

• PowerShares FTSE-RAFI US 1000 (PRF)
• PowerShares FTSE-RAFI Emerging Markets (PXH)
• PowerShares FTSE-RAFI US 1500 Small-Mid (PRFZ)