ETFs are fantastic, and we love them. First, however, we must understand a few things about them when constructing the absolute best portfolios. No two ETFs are the same, even if they hold similar underlying assets. ETFs can differ in a few ways, and one crucial to understand is ETF weighting methodologies.
What are the ETF weighting methodologies?
The traditional weighting methodology is capitalization-weighted. Market capitalization is the value of all company’s outstanding shares at their latest market price. So simply put, Market Cap = All Outstanding Shares * Latest Share Price. Based on that calculation, the highest market capitalization company in the world at this moment is Apple. Apple has a market cap of 2.2 trillion dollars, followed by Microsoft and Amazon.
So, when we purchase an ETF that uses a cap-weighted methodology in the tech sector or tracks an index like Nasdaq, where these stocks trade, ETF weighting will be mainly in Apple, Microsoft, Amazon, etc.
A good example is QQQ, an extremely popular ETF that follows the Nasdaq. We have over 100 holdings in it, yet 30% of the weight is in Apple, Microsoft, and Amazon. The top 10 holdings represent over 50% of the portfolio. What does this mean? Well, if Apple reports a bad result and the stock falls, the whole ETF falls with it, even though it is well diversified.
ETFs with equal weighting methodology allocate equal weights to all assets that they hold, no matter the difference between market size, earnings, or dividends of these assets. However, equal-weighted ETFs require more work as they have to be rebalanced whenever the weights start to slip as prices change.
With equal weighting, you avoid the problem of having too much exposure in a handful of giant companies that dictate the performance of an ETF. You also get a better-diversified ETF.
Higher earnings (profits) equal higher weight. Similar to cap-weighted ETFs, this is likely to produce heavily tilted allocation. This methodology severely punishes either low-earning companies or companies that break even or lose money. So, as an example, a tech sector ETF that follows this methodology would exclude Tesla for the majority of Tesla’s history as the company did not make any money. ETF like this would not include a vast majority of high-growth stocks.
Similar to earnings weighting but only focusing on the top line (revenues). No matter how much it costs them to generate that revenue, big revenue-generating companies will get the highest allocation.
Similar to earnings and revenue weighting but focusing on how much dividends the company pays. Higher the dividend, the higher the weight. This methodology could potentially be utilized by ETFs that try to achieve the highest possible dividend income.
So depending on what we are trying to achieve, we might select an ETF that is quite similar to its counterparts but uses a different ETF weighting method.
How different ETF weighting methods compare in performance?
Let’s run a hypothetical test, take a handful of ETFs with similar holdings but different weighting methods, and see how their performance has compared over the last decade or so.
Here are 3 ETFs.
SPY – Cap-weighted
RSP – Equal weighted
RWL – Revenue weighted
All three have almost identical holdings but different weighting methodologies. All three have exposure to large-capitalization U.S companies.
We invest a hypothetical $10,000 and see how much we would have in 2021.
Results are fascinating. Equal weighted ETF with the same holdings has outperformed cap and revenue-weighted counterparts and quite noticeably.
Here is the summary.
This is a whole percent better for RSP – equal-weighted than SPY – cap-weighted.
Here is how these ETFs differ in their exposure to different sectors. Again, holdings are the same, but because of weight differences, allocation is different.
RSP ends up being a lot more invested in Industrials and less in Technology. Much more in real estate and communication services.
What about fees?
As expected, equal weighting and revenue weighting require more work to maintain and thus impose a higher Management Expense Ratio (MER). So if your goal is to keep expenses as low as possible, SPY might be a better choice. However, given the outperformance of RSP even after higher MER, you would still be slightly better off.
ETF weighting methodology should be only one of the considerations when picking an ETF to add to your portfolio. Although historical backtesting shows that equal-weighted funds slightly outperformed, this doesn’t mean it will happen in the future. We must consider other things like how big the fund is, the expense ratios, and how the ETF fits within the overall strategy. In this example, knowing that SPY is significantly bigger than any other fund, it is also one of the oldest ETFs ever, along with a low expense ratio of just 0.09%. In many cases, it makes sense to pick SPY over RSP.
If you are not sure the best way to construct a portfolio for yourself, check out our easy-to-use investment guide and more ready-made portfolio ideas.