ETF Weighting Game

Part of my personal interest in exploring exchange-traded funds is their innovation, and arguably one of the first really innovative ETFs was the Rydex S&P 500 Equal Weight (RSP Quote) fund.

No doubt you know that the first ETF was the S&P 500 SPDR (SPY Quote), which came out in 1993 and mimics the market-capitalization weight of the S&P 500 index.

The RSP, launched in 2003, owns the same 500 stocks as the SPY, but instead of cap-weighting them, all 500 components are equal-weighted.

This methodology creates a lot of differences between the two in terms of composition. For instance, in SPY, Exxon Mobil (XOM Quote) has a 3.11% weight, compared with 0.2% in RSP.

The methodology also has a big effect on returns. As the chart below demonstrates, in recent years, RSP has significantly outperformed SPY. That's because unlike SPY, RSP is not a mega-cap product. The average market cap of a stock in RSP is $12.8 billion, which is more of a mid-cap number. SPY's average market cap, meanwhile, is $47.1 billion.

This distinction is very important. I believe it's the main contributor to RSP's dramatic outperformance -- and it could be the very reason that this outperformance won't always continue.

Small-cap stocks have outperformed large-caps this entire decade. Thus, RSP's dominance over SPY can easily be explained by its smaller market-cap holdings. But that doesn't make RSP better, it just makes it different.

At some point, mega-caps will again lead the market as they did in the late 1990s. It wouldn't be wise to give up forever on this part of the market.

Mid-Cap Leanings Lift RSP

Source: BigCharts

In fact, for the last few months, SPY has led RSP by a very slight margin as the risk-aversion correction of the last three months has hit smaller companies harder than large-cap.

Safety in the SPDR

Source: BigCharts

There are also some important sector differences. SPY has more than 10% of its weight in energy, compared with 6.3% for RSP. Energy has been a huge catalyst in the market for the past couple of years, and if you expect that to continue, you may want to add more energy exposure elsewhere.

RSP also has a much heavier weight in the consumer discretionary sector at 17.4%, compared with 9.7% in SPY. This could be a problem for RSP when this economic cycle ends and we potentially move into a big downturn that hampers consumer spending. In fact, for the past three months, the Consumer Discretionary Sector SPDR (XLY Quote) has lagged the Consumer Staples Sector SPDR (XLP Quote) by 7 percentage points.

Though RSP's outperformance over SPY is due to its smaller cap size, I don't believe that RSP should be viewed as a substitute for mid-caps or small-caps. Instead, it's a way to access the larger parts of the market with a smaller bias. Mid-cap ETFs such as the iShares S&P 400 MidCap Index (IJH Quote) fund, with an average cap of $3.4 billion, and the iShares Russell 2000 Index (IWM Quote) fund, with an average cap of $1 billion, are much smaller than RSP.

A lot of articles might point you to RSP as being "better" because it has beaten the S&P 500. I believe this ties in with the old saying about confusing genius with bull markets. The last few years has favored a smaller bias. But the bias will soon favor larger-cap -- if it is not already. That will last for a while, small-cap will be given up for dead and then will rotate back into favor. This isn't a specific prediction; it's how the market usually works.