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In the Performance Race, This Fund Is on the Wrong Track

Equal-weighting has merit, but make sure you measure with the proper benchmark.

Michael Rawson, CFA, 06/21/2013

Over the past 10 years, Guggenheim S&P 500 Equal Weight RSP has crushed the S&P 500, returning 9.48% per year compared with 7.23%. However, a quick glance at the Morningstar Style Box should alert investors that this is a poor comparison. The RSP portfolio behaves more like a mid-cap portfolio than the large-cap S&P 500. By that score, RSP has underperformed the S&P MidCap 400 by more than a percent per year. While fund marketers might like to advertise equal-weighting as providing a smarter beta or better diversification, the truth is that it is closer to a bait-and-switch. While the exposure is clearly mid-cap, equal-weighting does generate legitimate alpha from the forced buy low-sell high rebalance strategy. Investors would keep more of this alpha if it weren't for the fund's relatively high expense ratio of 0.40%

A Better Beta
Of all of the non-market-cap-weighted investment strategies, the simplest to conceptualize is equal-weighting. Here, each stock has the same weighting in the portfolio. In the equal-weighted version of the S&P 500 Index, giant caps like Apple AAPL carry the same heft as mid-caps like AutoNation AN, despite the fact that Apple has a market cap more than 200 times larger. Thus, the fund is a better supplement for mid-cap exposure and is best used as a satellite or tactical position rather than a core holding.

Source: Morningstar.

Market-cap-weighted indexes skew toward the largest companies in the index, leading to a concentration in giant-cap names. A full 20% of the S&P 500 is held in just 10 stocks. That concentration gets muted in an equal-weighted fund such as RSP, so that just about 2% of the equal-weighted S&P 500 resides in the top 10 stocks. In essence, the equal-weighted index takes large underweightings in a handful of mega-cap stocks and takes small overweightings in many large- and mid-cap stocks. While some might argue that this lowers concentration risk, those mega-cap names tend to have very low volatility compared with mid-caps.

One way to measure the extent of exposure to smaller-cap stocks is to run a regression model. Regression is a statistical method used to break down returns by source or to analyze risk exposures of a fund. Since 2003, the equal-weighted version of the S&P 500 has had a beta to the traditional Fama-French SMB (small minus big) factor of positive 0.19 while the S&P 500 has a beta of negative 0.15, indicating that it tilts in the opposite direction toward mega-caps.

Still, that regression also reveals that equal-weighting generated an excess return, or alpha, of about 0.11 basis points a month. A paper by Yuliya Plyakha, Raman Uppal, and Grigory Vilkov demonstrates that the source of the alpha in an equal-weighted strategy is the rebalance. But this is for the index. In the real world, RSP has to overcome the expense ratio and trading costs. As a result, RSP investors could only capture an alpha of 0.07% per month or about 0.84% per year.

Is Now the Right Time to Increase Mid-Cap Exposure?
Despite the recent uncertainty, the stock market is near all-time highs. The S&P 500 trades at a price/trailing earnings of about 18.3 times, which is rich compared with historical multiples. Our equity analysts, who assign price/fair value estimates on 98% of the stocks in the index, see those stocks as trading at a price/fair value of 0.98. However, by equal-weighting and putting more emphasis on mid-cap stocks, the price/fair value becomes slightly more expensive at 1.01 times. In addition, these mid-caps are slightly lower quality, with only 19.6% of assets having a wide moat, compared with 43.0% for the S&P 500. The lower moat ratings are reflected in the greater volatility of RSP, 17.8% compared with 14.6% for the S&P 500. Investors in RSP should be prepared to greater volatility than they would have in the S&P 500.

Michael Rawson, CFA is an ETF Analyst with Morningstar.

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