Contributor, Benzinga
April 3, 2023

Looking to reduce concentration risk in your portfolio? Holding a large volume of your assets in a single stock, industry, sector or geography can be risky. Prudent and risk-aware investors diversify across these factors.

To do so, many investors buy index exchange-traded funds (ETFs), which can provide broad coverage across a variety of equity sectors, styles and sizes. However, owing to their construction, some index ETFs may actually lack diversification. Why is this?

The problem stems from their market-cap weighted methodology, which can cause them to be overweight in certain sectors like technology or sizes like large-cap stocks. To avoid this situation, investors can buy equal-weight ETFs, which create and manage their portfolio of stocks using a different set of rules.

Interested in learning about how these ETFs work, the best options on the market and their pros and cons? Keep reading this article to find out. 

What Are Equal Weight ETFs?

Your average index ETF is constructed using a market-capitalization-weighted methodology. Each stock in the index and the ETF are assigned an allocation proportional to its market-cap weight. Accordingly, large-cap stocks are held in higher proportions to mid and small-cap stocks.

For example, looking at the popular SPDR S&P 500 ETF Trust (NYSEARCA: SPY), as of March 16, 2023, the largest holding is Apple Inc. (NASDAQ: AAPL) at 7.03%. The 10th largest holding is UnitedHealth Group (NYSE: UNH) at 1.33%. Apple has a much higher weighting than UnitedHealth owing to its much larger market cap.

On the other hand, an equal-weighted ETF doesn't care about the market-cap weight of each of its stocks. Small-, mid- and large-cap stocks will be held in the same proportions and rebalanced to these proportions periodically. On average, this means that an equal-weighted ETF will no longer be overweight large-cap stocks. It will usually have a higher proportion of mid and small caps. 

Take the Invesco S&P 500 Equal Weight ETF (NYSEARCA: RSP), for example. This ETF holds all 500 stocks in the S&P 500 index in equal weightings, which works out to a target allocation of 0.2% per stock. This is why Meta Platforms Inc. (NASDAQ: META), a large-cap stock currently holds a 0.36% weight, close to that of Catalent Inc. (NYSE: CTLT) at 0.33%, which is much smaller. 

Equal-weight ETFs can quickly become unbalanced over time. Notice above that both Meta and Catalent currently hold weights above their assigned 0.20%. Stocks move up and down, so the outperforming ones grow in market cap and thus weighting. To remedy this, equal-weight ETFs periodically rebalance their portfolio, usually on a quarterly basis.

Types of ETFs That Are Equally Weighted

Equal-weight ETFs can be categorized based on their underlying asset. Some types of equal-weight ETFs on the market and examples of popular picks currently include:

  • Equal-weight index ETFs: These ETFs take an index like the S&P 500, Nasdaq 100 or Dow Jones Industrial Average and reorganize them so each stock in the index is assigned the same allocation. Examples include the First Trust Dow 30 Equal Weight ETF (NYSEARCA: EDOW), the Direxion NASDAQ-100 Equal Weighted Index Shares (NASDAQ: QQQE), the Invesco S&P 100 Equal Weight ETF (NYSEARCA: EQWL) and the Invesco Russell 1000 Equal Weight ETF (NYSEARCA: EQAL).
  • Equal-weight sector ETFs: These ETFs target a specific sector like technology, healthcare or financials and hold the stocks in the sectors in equal weights. This method can help reduce the concentration in large-cap stocks for certain sectors that are dominated by them, such as technology and energy. Examples include the Invesco S&P 500 Equal Weight Utilities ETF (NYSEARCA: RYU), the Invesco S&P 500 Equal Weight Industrials ETF (NYSEARCA: RGI) and the Invesco S&P 500 Equal Weight Health Care ETF (NYSEARCA: RYH).
  • Equal-weight industry ETFs: These ETFs target specific niches in sectors – for example, the aerospace and defense industry within the larger industrials sector or the oil and gas industry in the overall energy sector. Examples of these ETFs include the SPDR S&P Semiconductor ETF (NYSEARCA: XSD), the SPDR S&P Bank ETF (NYSEARCA: KBE) and the SPDR S&P Aerospace & Defense ETF (NYSEARCA: XAR).

Benefits of These Types of Funds

Equal-weight ETFs have become popular recently because of investor concerns over the possibility of concentration in traditional market-cap-weighted index ETFs. Some of their benefits include:

  • Diversification: Equal-weight ETFs can offer greater exposure to small- and mid-cap stocks, along with exposure to under-represented industries like utilities and real estate. 
  • Outperformance: Equal-weight ETFs can potentially outperform market-cap-weighted ETFs under conditions that favor small and mid-cap stocks. 
  • Balance: Equal-weight ETFs can help investors avoid having a handful of large-cap stocks influence the overall performance of their investment. 

Drawbacks of These Funds

Equal-weight ETFs have numerous traits that may make them undesirable to some investors, especially those who believe in the efficient market hypothesis and the dominant market-cap-weighted methodology.

  • Turnover: Equal-weighted ETFs tend to have much higher portfolio turnover and trading costs compared to market-cap-weighted index ETFs. 
  • Fees: Equal-weighted ETFs usually charge higher expense ratios than their market-cap-weighted index counterparts. 
  • Underperformance: Equal-weighted ETFs can underperform, usually during economic conditions that favor the large-cap stocks that dominate market-cap-weighted ETFs. 

Compare Brokers for ETFs

Investors looking to research and choose the best equal-weight ETFs can use Benzinga to compare the available selections available on the market. Not all equal-weight ETFs will indicate they are in their name, so it's important to carefully read their ETF fact sheet and prospectus to see if their methodology is truly equal-weight. Here is a list of brokers that support equal-weight ETF trading and offer research tools to help investors select the right one.

Frequently Asked Questions

Q

Are equal-weight ETFs a good idea?

A

Equal-weight ETFs are a unique type of investment best suited for those with specific goals and views on the market. Investors who don’t believe in the efficient market hypothesis and the default market-cap-weighted methodology can use equal-weighted ETFs as an alternative. The same goes for investors who want to reduce the influence of a handful of large-cap stocks on their portfolio, increase exposure to small- and mid-caps or ensure a more even distribution of stocks across all sectors. Investors who buy an equal-weight ETF must be willing to accept periods of possible underperformance, along with higher expense ratios and greater portfolio turnover. 

Q

Are equal-weight ETFs a safe investment?

A

Like all equity investments, equal-weight ETFs are not safe. Given that they hold stocks, they can experience sharp unrealized losses and high volatility during bear markets, corrections and crashes. Just because they have a more even distribution of market cap sizes and sectors does not make them more resilient to crashes. When crashes occur, all stocks tend to fall in tandem due to market risk, which is systematic and unavoidable. For safety, it may be wise for low-risk investors to complement an equal-weight ETF with short-term Treasury and money market ETFs. These assets have very low market risk and can help preserve capital when the worst happens. 

About Tony Dong

Tony Dong, MSc, CETF®, is a seasoned investment writer and financial analyst with a wealth of expertise in ETF and mutual fund analysis. With a background in risk management, Tony graduated from Columbia University in 2023, showcasing his commitment to continuous learning and professional development. His insightful contributions have been featured in reputable publications such as U.S. News & World Report, USA Today, Benzinga, The Motley Fool, and TheStreet. Tony’s dedication to providing valuable insights into the world of investing has earned him recognition as a trusted source in the finance industry. Through his writing, he aims to empower investors with the knowledge and tools needed to make informed financial decisions.