Market-cap weighted vs. equally weighted index funds: Which are better?

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The idea of heading to the beach has some of us indulging in a little last-minute dieting in an effort to shave off a few pounds before hitting the water. Weight also matters to investors when it comes to how they divvy up their portfolios.

Some investors like to put an equal amount of money into each stock. They build equally weighted portfolios.

On the other hand, many index investors prefer to mimic the market, which means they devote a larger fraction of their portfolios to large stocks rather than small ones.

For instance, Royal Bank of Canada is the largest stock in Canada based on its market capitalization (number of shares times price per share). It made up 6.6 per cent of the S&P/TSX composite index at the end of May.

If the index had been split equally between its 234 stocks, RBC would have made up only about 0.4 per cent of it.

Many index funds use market-cap weighting for a few reasons. Importantly, it allows them to manage a lot of money without overly affecting stock prices. After all, it's relatively easy to buy the largest stocks in quantity whereas it can be hard to put a great deal of money to work in small stocks. In addition, market-weighted indexes don't need to be rebalanced frequently because when a stock's price changes, its weight in the portfolio automatically adjusts appropriately. (Changes to the index caused by mergers and other corporate actions typically require a modest amount of rebalancing.)

But it is worth giving equally weighted portfolios a second thought because some specialty index funds take advantage of it. For instance, the BMO S&P/TSX Equal Weight Banks Index ETF (ZEB) is a popular sector fund that follows the comically named S&P/TSX equal weight diversified banks index. It holds an equal amount of the, count them, six bank stocks in the S&P/TSX composite index. (Long-term investors should probably buy the six stocks directly.)

While the ETF's portfolio starts with about one-sixth of its assets in each bank stock, that fraction will change as stock prices vary from day to day. As a result, the portfolio is rebalanced semi-annually to counteract such movements, which may trigger capital gains taxes.

The extra effort that equal weighting requires can be worth it because over the very long term, large stocks tend to underperform their smaller brethren. (Giant stocks have a history of doing particularly poorly, which is something Nortel's shareholders found out the hard way.) It's a tendency that shows up in the race between market-weighted and equally weighted versions of the same index.

For instance, the regular market-weighted S&P 500 saw average annual gains of 7.4 per cent during the decade through to the end of May. It trailed the equally weighted version of the S&P 500, which climbed by an average of 8.7 per cent annually over the same period.

It is important to point out that there are times when large stocks beat small stocks. For instance, over the past five years, the market-weighted S&P 500 beat its equally weighted counterpart by an average of about 0.2 of a percentage point annually.

Complicating matters, equally weighted index funds often charge more than their market-weighted siblings. The fee difference can narrow and sometimes reverse the performance gap between the two.

In the United States, the SPDR S&P 500 ETF (SPY) provides market-weighted exposure while the Guggenheim S&P 500 Equal Weight ETF (RSP) divides its portfolio equally. The equally weighted ETF outperformed by about 0.8 of a percentage point annually over the past decade despite an unfavourable annual fee difference of 31 basis points. (A basis point is 1/100th of a percentage point.)

In Canada, investors can buy the popular market-weighted iShares S&P/TSX 60 Index ETF (XIU) or the thinly traded Horizons S&P/TSX 60 Equal Weight Index ETF (HEW). In this case, the equally weighted ETF hasn't been around for 10 years and it costs 41 basis points more than the regular ETF. But the index it follows outperformed the market by an average of 1.0 percentage points annually over the past decade.

Put the options on the scale this summer because it might be worth moving to equally weighted indexes, ideally in tax-sheltered accounts.

Norman Rothery is the value investor for Strategy Lab. Globe Unlimited subscribers can read more in the series at tgam.ca/strategy-lab.