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ETF Specialist

The Not-So-Secret Sauce in Equal Weighting

Equal-weighting strategies can hold appeal, but only if you understand the risk you are taking.

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Of all of the non-market-cap-weighted investment strategies, the simplest by far 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 100 times larger. While the equal-weighted strategy might be marketed as a better way to achieve beta, it is best used a satellite or tactical position rather than a core holding.

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 names. That concentration gets muted in an equal-weighted fund such as Guggenheim S&P 500 Equal Weight (RSP), so that just 2% of the equal-weighted S&P 500 resides in the top 10 names. In essence, the equal-weighted index takes large underweightings in a few 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, while the volatility of mid-caps is generally much higher. The volatility of the 10 largest stocks in the S&P 500 was just 17% over the past year, but the average volatility of the remaining 490 stocks was 29%

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Michael Rawson does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.