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Understanding 'Equal Weight'

Michael Rawson, CFA

Michael Rawson: Hello, I am Michael Rawson, ETF analyst with Morningstar.

ETFs have been a growth area of the market, but when people think of ETFs, they either think of boring index funds or scary high frequency trading.

Those criticisms really don't apply to the Rydex S&P Equal Weight fund.

Joining me today is Tony Davidow, managing director with Rydex. Tony, thanks for joining me.

Tony Davidow: Mike, thanks for having me.

Rawson: Absolutely. Rydex S&P Equal Weight takes the stocks that are in the S&P 500, those large-cap stocks that we're all familiar with, but instead of market cap weighting them, it equal weights them. Now a common criticism of this approach is that you're basically giving a small-cap tilt and any boost in performance is coming from taking on risky small-cap exposure. How do you respond to that criticism?

Davidow: I think as a starting point, yes, we own the same 500 names that are in the S&P, and we equal weight them. So, although we do benefit from a little bit more of a small-mid exposure, we're actually owning large-cap stocks. The smallest name in the S&P today is Office Depot. We would argue it's a more rational way of thinking about exposure in the portfolio and I'll give you one example.

If you look at the largest name, Exxon and you look at the smallest name, Office Depot, you are making a 300 times bet on the performance of Exxon relative to Office Depot. We would just argue, equal weighting is a more rational of diversifying your exposure. We do benefit from more small- and mid-cap exposure, but it's not a small cap play per se.

Rawson: Okay. However, small caps have had a tremendous run over the past 10 years, certainly they've done much better than large caps. Now in the late 1990s during the go-go years for the tech bubble, large caps performed very well. Small caps sort of underperformed. Does the recent good performance in small caps concern you going forward that that trend might reverse?

Davidow: It doesn't. We've actually looked at long-term historical periods, and we've generally performed quite well. Again, we're providing more diversified exposure. A period of time that we might not perform as well would be a period when the market was dominated by mega-cap names. I am not sure that any one is predicting that mega caps again will dominate the market as they did in the late '90s. So we feel very comfortable with the composition of the portfolio, and we feel very comfortable about their long-term results.

Rawson: Now there are two other aspects to the equal-weighting strategy besides the small-cap tilt. There are two other aspects that I'd like to discuss. First of all, by rebalancing every quarter back to equal weight, it forces you to buy low and sell high. So it has this disciplined aspect to it.

Secondly, there is a reduced concentration in those mega-cap names. In the S&P 500 some people are surprised to learn that a huge portion of their portfolio is actually invested in just a handful of stocks. That's not the case with the Rydex Equal Weight because every stock is equal weight, so you have less exposure to mega cap stocks. Could you talk about these two alternate strategies in Rydex Equal Weight?

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Davidow: Absolutely, and I think it's really important to note. So the rebalancing does add significant value over time, because essentially what ends up happening is when we rebalance our portfolios once a quarter, what we're doing is, we're actually rebalancing back to that equal weight position. So essentially we are taking money away from sectors and strategies that have performed well.

So if it's a rising value market, we're going to be selling value and buying growth, and it has actually--as we've looked at this over time--it's actually been very helpful as we're taking money away. If you believe in reversion to the mean, you can understand the value that the rebalancing has in the overall portfolio.

The second point, which is equally as important, is this whole concentration issue. We touched on it a little bit with the large-cap names having such a disproportionate impact on the portfolio of returns. The top 10 names represent roughly 20% of the portfolio. The top 50 names represent 50% of the portfolio. So, we do think there is a real value and a diversification benefit by having more exposure equally allocated across the deciles.

Rawson: Great. I would just like to remind investors that small caps have performed incredibly well. There is some speculation that they may not do as well as they have in the future going forward. So, in your portfolio if you were to own the Rydex S&P Equal Weight fund, you want to monitor your asset allocation to the different market-cap ranges, large cap and small cap, and take all those factors into consideration.

Again, it's Michael Rawson ETF Analyst with Morningstar here with Tony Davidow from Rydex. Tony, thank you for joining me.

Davidow: Thanks for having me.