Do equal weight ETFs outperform?

Does placing an equal bet on each security in an index yield better results than allowing companies with larger market capitalizations to dominate?

Ask Zinetula Bilyaletdinov. As coach of the Russian Olympic hockey team, his success at the 2012 World Championship put him under tremendous pressure to win a gold medal. With 16 NHL players and 10 from the Russian KHL, he chose to “equal weight” his team, using four forward lines. This meant that key players like NHL stars Alexander Ovechkin and Evgeni Malkin get an average 20 to 25 minutes per game each, only played about 15 minutes per game each for Russia.

By contrast, the Canadian gold medal team relied on three lines, giving its best players more ice time and increasing their probability of scoring. Even though Canada’s top forwards may not have played to their potential, defenceman Drew Doughty, who saw a disproportionate amount of playing time, delivered. In this instance, cap weighting was a successful strategy.

Equal versus cap-weighted

Alternative indexing proponents criticize cap-weighting because it emphasizes companies that have done well in the past. They further claim that, by giving each security the same weight, smaller more rapidly growing companies are given more opportunity to contribute. At the same time, exposure to larger companies that implode is reduced (see “Growth of $1,000,” this page).

But what are the characteristics of the Canadian equal weight index, and how do we know whether to use it or a cap-weighted index? The chart “Sector weight differences,” this page, helps explain a small-cap and lower-dividend bias: reduced exposure to large capitalization, higher-dividend-paying financials, for example.

The estimated yield for the Horizons S&P/TSX 60 Equal Weight, HEW is $2.26, versus $2.80 for the iShares S&P/TSX 60 Index Fund, XIU. For HEW, turnover was 29.2% in 2013. That’s higher than the broad index because of quarterly rebalancing, and turnover added costs of between 0.01% in 2010 to 0.14% in 2013 for periods ending June 30, 2013. The Fama/French three- factor model identified small-cap and value factors as sources of possible outperformance. Inefficient price discovery for small companies is one explanation. Small cap size has not proven to offer a performance advantage over a broad index in Canada in recent testing.

Equal-weight indices can have different sector exposures from their cap-weighted counterparts, so examining underlying holdings is important.

In Canada, the most obvious difference for the equal weight index is in the financial sector. Also very different are materials, consumer discretionary and staples. The volatility of the equal-weight index was consistently higher than that of the cap-weighted index in short term, one-year daily testing. This is counterintuitive because equal weight sounds like it should be more diversified, but smaller companies generally have higher volatility than larger ones.

The Canadian equity market is highly stratified with a small group of large companies and a vast array of small ones. Equal weight offers an effective way to diversify risk associated with any one company (specific or unsystematic risk), so for investors looking for sector or industry exposure, equal weight indexing make good sense.

The financial crisis has taught us that rebalancing to a fixed asset mix is best for do-it-yourself investors seeking simplicity. Portfolio managers and advisors using Canadian equities must decide where to allocate an investor’s risk budget, including: sectors, asset classes or volatility. Equal-weight indices have their own biases, which can only be understood by examining the underlying holdings and comparing them with their cap-weighted siblings. Equal weighting is an active strategy that’s more volatile and expensive, so advisors need to have a good reason to use it. If you don’t, ask the Russian coach. You’ll find him in the unemployment line.

Canadian equal-weight ETFs