The ETF industry continues to evolve before our eyes, with a new line of nine sector ETFs from Rydex debuting Tuesday. Instead of weighting by market cap, like the first generation of sector ETFs, or by a fundamental measure like dividend yield, the Rydex funds weight stocks equally.

The practical effect is that the biggest stocks by market cap will have less of an influence on returns. The mega caps usually don't provide leadership until the end of the stock market cycle, so it makes sense to have a tilt towards smaller companies most of the time.

Equal weighting of the funds brings the average market cap down considerably. The average market cap for the Industrial Select Sector SPDR ( XLI) is $99.78 billion, but only $25.84 billion for the similar Rydex S&P Equal Weight Industrials ( RGI).

Rydex first did this with an S&P 500 fund, the Rydex S&P Equal Weight Index Fund ( RSP). In addition to the industrial fund, it has now brought to market:
  • Rydex S&P Equal Weight Consumer Discretionary (RCD)
  • Rydex S&P Equal Weight Consumer Staples (RHS)
  • Rydex S&P Equal Weight Energy (RYE)
  • Rydex S&P Equal Weight Financial (RYF)
  • Rydex S&P Equal Weight Health Care (RYH)
  • Rydex S&P Equal Weight Materials (RTM)
  • Rydex S&P Equal Weight Technology (RCD) (RYT)
  • Rydex S&P Equal Weight Utilities (RYU), which includes the telecom sector.
  • These ETFs are based on S&P equal weight sector indices created several years ago. They should be similar to the sector SPDRs from StateStreet in terms of holdings, except for the fact that the sector SPDRs are cap weighted.

    Citigroup ( C) is the largest holding in most of the financial sector ETFs, with a 9.11% weight in the Financial Select Sector SPDR ( XLF) and a 7.73% weight in the iShares DJ Financial Sector Index Fund ( IYF). Citigroup only has a 1.13% weight in the equal weight fund. Since Citigroup has lagged the Financial Sector SPDR by about 9% year to date, the lighter weighting in Citi is probably a good thing.

    Exxon Mobil ( XOM) is the behemoth in the various energy sector ETFs. It has a whopping 23.16% weight in the Energy Sector SPDR ( XLE) and a 24.27% weight in the iShares DJ Energy Sector Fund ( IYE) compared to just 3.5% in the equal weight energy ETF. Exxon Mobil has lagged the sector, as measured by the energy SPDR, by a wide margin for most of the bull market for energy of the last few years, but Exxon Mobil has led the sector for the last three months.

    General Electric ( GE) weighs in at 19.77% of the Industrial Sector SPDR, 19.67% of the iShares DJ Industrial Index Fund ( IYJ) but only 1.91% of the equal weight industrial fund. As with the others, GE has been a laggard, trailing the Industrial Select Sector SPDR by 8% year to date.

    The funds will have a 0.50% expense ratio and rebalance once a quarter. Prices move every day so the funds will be out of balance most of the time, but they will never be anywhere as lopsided as the cap-weighted funds. The thing here is not whether Procter and Gamble is 2.4% or 2.8% of the Equal Weight Staples Fund, but that it is not and never will be 17% of the fund.

    These funds may be less than ideal now if you think we are close to the start of the next bear market. When the next downturn comes, it's likely that the equal weight funds will lag the cap-weighted funds. This does not make equal weighting a bad idea -- no product is likely to lead for the entire duration of a stock market cycle.
    At the time of publication, Nusbaum was long the iShares Dow Jones U.S. Financial Sector Index Fund and the iShares Dow Jones U.S. Industrial Sector Index Fund in client accounts, although positions may change at any time.

    Nusbaum is a portfolio manager with Your Source Financial of Phoenix, Ariz., and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback; click here to send him an email.

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