The popular market-proxy S&P 500® index is market-cap weighted. This is one of the factors that helps reduce the turnover of ETFs tracking this index. For example, the iShares Core S&P 500 ETF (IVV) has a turnover rate of only 4%. The following chart, produced by the Alpholio™ App for Android, shows the characteristics of a portfolio composed solely of this ETF:
(Note that Alpholio™ uses a broader ETF as a representation of “the market”; hence, the beta of IVV is different from the conventional one and alpha from zero.)
However, market-cap weighting implies that the largest companies’ stocks have the highest impact on the index. While returns of mega-caps in the index tend to be less volatile, they are usually lower than those of their smaller-cap peers. To overcome this limitation, other ETFs weight equities in the index differently. For example, the Guggenheim S&P 500™ Equal Weight ETF (RSP) assigns each of the 500 stocks a 0.2% weight. This tilts RSP toward smaller-cap equities in the index and results in a 18% turnover. Over the same analysis period, RSP produced markedly higher returns than IVV but at the expense of an elevated volatility and a slightly lower Sharpe ratio:
In addition to overweighting of mega-caps, some economic sectors in the index dominate others, as shown in the latest edition of S&P Capital IQ The Outlook:
To counteract this, the ALPS Equal Sector Weight ETF (EQL) applies the same weight to nine sectors (with telecommunication services considered part of information technology). Here are the characteristics of a portfolio consisting solely of this ETF over the identical analysis period:
While the annualized return of EQL was lower than than of IVV or RSP, it was more than adequately offset by a decrease in volatility, which resulted in an improved Sharpe ratio and maximum drawdown.
What if the investor wanted to equal-weight all ten sectors instead of just nine, i.e. keep telecoms separate from IT? To do so, the investor could construct a portfolio of Vanguard sector ETFs, excluding the Vanguard REIT ETF (VNQ). That is because real estate stocks are currently part of the financials sector and not expected to become a separate asset class until mid-2016. Here is how such a portfolio, rebalanced quarterly (just like EQL), performed over the same analysis period:
The Vanguard sector portfolio had the second highest alpha and Sharpe ratio as well as the second lowest standard deviation (a measure of volatility of returns).
The above analysis period was dictated by the inception date of the EQL, the youngest of all the ETFs used. Arguably, this approximately six-year period may be considered too short and not representative of performance over a full economic cycle. However, it was interesting to see that while equal-weighting the index on a security level produced highest absolute returns, equal-weighting on a sector-level delivered the highest risk-adjusted returns.