Can the equal weight ETF approach finally pay off?

It’s no secret that passive investing through exchange traded funds (ETFs) is a powerful tool that can combine low fees with excellent returns.

Instead of the old days in when you had to select your own shares and hope they kept up with the performance of the overall market, ETFs instead rely on the market they are invested in and match those overall returns with great accuracy.

That is why they are known as passive funds, because they buy all of the shares in a particular index rather than trying to pick individual winners and avoid losers, buying these shares in proportion to the size of the companies they’re investing in.

Despite the huge success of cheap and diversified index ETFs, there has been a lot of innovation by many ETF providers to try to come up with a new formula that combines high returns with lower risk.

Splitting money without considering size

One of those attempts is known as equal-weighted index investing.

True to the label such funds do not buy shares in an index in the same proportion as they are represented in the index – Instead they buy the same dollar amount of each company in that index.

While it might seem like it’s small difference, in reality this is quite a dramatic change because the investor is getting the same exposure to the 200th company in the index as they are the biggest company.

The theory is that smaller companies should be able to grow faster than larger ones so by getting exposure to more of the smaller companies on the index the performance of the fund may be higher than that of the index.

Also, the equal weight approach should avoid specific cases in which large companies become overvalued.

Indeed, there are times when such an approach has resulted in higher returns but in real life the results from equal weighted ETFs have not been as good as expected in all market conditions.

When buying more Commonwealth was a great idea

Recent history provides some good examples on the familiar ASX 200 index, of which the big four Australian banks make up more than 24%

An equal weight investor might expect that these banks could be a drag on the performance of the index but in reality in recent times the big four banks and in particular the stunning outperformance of the Commonwealth Bank (ASX: CBA), have made such a strategy look foolish.

A straightforward ASX 200 index fund just kept buying those Commonwealth Bank shares even as brokers filed almost unanimous reports that they were overvalued and the results were outstanding for those index ETFs.

The argument that equal weighted ETFs would avoid buying overvalued stocks and instead buy more early stage companies with stronger growth prospects didn’t work on the ground in this case.

The argument for equal weighted ETFs though is that over a longer time period, they should outperform a standard index ETF.

The question is what time period is appropriate?

Tech giants make a mockery of equal weight – for now

If we look at an equal weighted exchange traded fund on the S&P 500 index, it has  underperformed the S&P 500 index by 3.5% on average over the five years to September 30.

In the case of the BetaShares S&P 500 Equal Weight ETF (ASX: QUS), much of that underperformance relates to the impact of the technology giants Apple, Alphabet, Google, Microsoft, Tesla, Nvidia and Meta.

During that time this ETF would have been continually selling shares in these fast-rising technology stocks and buying more of the smaller companies in the index.

Over time the outperformance of this technology group may reduce and if that is the case the lack of concentration risk in the equal weighted ETF should start to generate some better returns.

Measuring quality and moats

Other semi-active approaches by ETF providers have proved to be more successful – particularly those that use filters to measure the quality of earnings or the competitive moat or advantage that some companies have around their earnings.

Such approaches normally come with higher fees which investors don’t mind paying if they produce high returns.

There will probably come a day when the equal weighted ETFs have their time in the sun as markets go through different phases in which qualities such as growth or value might predominate.

We could be in such a phase right now and not know it or it could be years down the track but for those who follow the equal weight thesis, they are confident that one day their higher returns will come.