Posted on 02/07/2011
That's the provocative title of a recent article in Smart Money. The article makes a controversial claim:
"The Journal of Indexes gives academic treatment to bland investments, and so might not seem a likely source of hot controversy. The latest issue, however, is packed with it--and has greatly annoyed mutual fund titan Vanguard. A report therein gives new support for the claim that most index investors are unknowingly missing out on a large portion of the returns that their passive approach ought to provide."
Are investors really missing out on a large part of the passive return? The article implies that a variety of alternative weighting methods like efficiency weighting, volatility weighting, equal weighting, and fundamental weighting provide better returns than traditional capitalization weighting. ETFs are even available for some of these alternative methods, most notably equal weighting (RSP) and fundamental weighting (PRF). Over the eleven-year period cited in the article, all of them have better returns than capitalization weighting.
Today, we would like to turn our focus specifically to the equal weight versus cap weight debate. Until recently, equal weighting versus cap weighting analysis had been limited to the US market, more specifically Large cap equities. However, Rydex has now launched six new equal weighted ETFs covering international equity indices as well as small and mid cap domestic equity indices.
We have compared all of Rydex's equal weighted ETFs (minus their equal weighted sector lineup) to their corresponding Cap weighted counterparts. In all seven comparisons shown in the table below, the equal weighted Rydex ETF outperforms its cap-weighted brethren by 10% more. The performances of all of the ETFs were measured within a two year period, from February, 2009 through February, 2011.
The pair that shows the largest dispersion between its equal and cap weighted funds was the Rydex Russell 1000 Index. The Equal Weight ETF (EWRI) shows a gain of 99.11%, while the Cap Weighted version is posting a return of 60.88%. That's a difference of more than 38% just from changing the weighting methodology! Another noteworthy comparison is between the funds in the emerging market arena. The EWEM, which equally weights the stocks in the MSCI Emerging Markets Index, was up 133.13%. On the other hand, the EEM was up 99.9%, giving equal weighted investors an upper hand to the tune of 33.23%.