ETF investing at its best – cheapest, in other words – means buying exchange-traded funds that track the biggest, most widely followed indexes.
But how many different cheap funds tracking the likes of the S&P 500 and S&P/TSX Composite Index can Canada’s ETF market support? Not that many, which is why companies in the ETF business are creating products that try to improve on the big indexes.
One of these product types, the equal weight index fund, has caught the eye of a Globe and Mail reader. “Do you think an equal weight index fund will outperform an equity weight index fund over the long term?” he asked recently. The short answer is no, but I’m happy to be proven wrong as equal weight funds establish a long-term record of performance.
The traditional stock index weights stocks by market capitalization, which means the most widely held stocks are the biggest holdings. Royal Bank of Canada and Toronto-Dominion Bank are Canada’s two biggest companies by market cap and together they account for about 12.5 per cent of the S&P/TSX Composite. Bank of Nova Scotia, Bank of Montreal and Canadian Imperial Bank of Commerce account for another 8.5 per cent of the index.
A drawback of market cap weighted indexes is that they can live or die by their biggest holdings. If banks tank, then the S&P/TSX is in trouble. Equal weight indexing means every stock in an index has the same weighting and thus cannot single-handedly propel the index lower – or higher.
The Horizons S&P/TSX 60 Equal Weight Index ETF (HEW) has delivered an annualized five-year return of 4.8 per cent. The traditional index ETF alternative to HEW is the iShares S&P/TSX 60 Index ETF (XIU), which made 5.5 per cent over the past five years. XIU has a 12-month return to June 30 or 4.7 per cent, compared with 1.2 per cent for HEW.
The still new Invesco S&P 500 Equal Weight Index ETF – CAD-hedged (EQL.F) has a one-year loss of 0.7 per cent, compared with a 12-month gain of 8.1 per cent for the iShares Core S&P 500 Index ETF CAD-Hedged (XSP). The underlying (equal weighted) index for EQL.F has an annualized 10-year return of 14.1 per cent, compared with 14.2 per cent for XSP’s underlying (equity weight) index.
The reader who asked about equal weight index ETFs wondered about the impact of fees on returns. HEW has a management expense ratio of 0.6 per cent, compared with 0.18 per cent for XIU. EQL.F comes in at 0.26 per cent, compared with 0.11 per cent for XSP.
Equal weighting seems competitive with traditional indexing, but weighed down by higher fees. So far, there isn’t a strong argument for dumping the tried and true approach for an equal weight ETF.