By Paul Weisbruch of Street One Financial

ETF investors -- retail and institutional -- as well as investment advisers using exchange-traded funds in their client portfolios likely use portfolio-rebalancing periodically. Some advisers prefer to weight their client portfolios to favor value over growth and then rebalance the portfolios to bring their weightings in line with their original targets.

One simplistic example is an adviser who uses a 60-40 value-to-growth split in client portfolios and rebalances once per year in December. If during the following year value stocks are in vogue in the market, this 60% value to 40% growth could look like 70-30 or even 80-20. That is because some stocks, or ETFs, will rise in value, others will fall, some will remain stagnant and the original "model weightings" will rarely be in line with the initial targets after market forces go to work and take over. Thus, a rebalance may consist of taking profits on those holdings that have run the furthest and reinvesting those profits by buying more shares of those holdings in the portfolio that underperformed.

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Others may rebalance by buying their winners and selling their losers, in essence doubling up on those stocks or ETFs that have fared the best in the previous period and dumping the underperformers. With a rebalancing schedule, one is adding an element of active management to a portfolio of index ETFs and likely attempting to add value in terms of alpha to his or her stated benchmarks. Many individual investors employ an investment adviser so that these rebalance needs are met systematically and professionally, and it pays to understand how different ETF index methodologies work so that they can aid the investor's rebalancing expectations and trading decisions.

Let's start with the basic "market-cap weighted" indices, like the S&P 500, S&P 400, S&P 600, Russell 1000 and Russell 2000. The index mechanisms are fairly simple. The weightings of the stocks included in these indexes are individually determined by the stock's price, multiplied by shares outstanding, otherwise known as market capitalization. Therefore, stocks that have a large number of shares outstanding or a high stock price tend to dominate the upper part of the index weightings, so market-cap weighted indices tend to have a large-cap bias.

Investors who are happy with the benchmark's index returns minus the expense ratio of the ETF tend to stick with market-cap weighted ETFs and attempt to add alpha through overweighting growth or value around the benchmark, according to their market prognostications.

How do market-cap weighted ETFs such as the S&P 500 Index SPDR ( SPY), iShares S&P 500 Index ( IVV), iShares Russell 2000 ( IWM) and Vanguard Large-Cap ETF ( VV) rebalance?

Well, the short answer is they don't rebalance, as there is no pre-defined rebalancing schedule within the market-cap methodology. Unfortunately, if one's motivation is to outperform his or her benchmark, using market-cap-weighted ETFs requires precise timing on when to be long the market and when to be in cash because simply buying and holding a market-cap-weighted ETF will lose to the benchmark 100% of the time due to the expense ratios associated with holding the ETFs. In essence, market-cap-weighted ETFs are rebalanced by the market's fluctuations in price, and as one university endowment manager once aptly stated to me, "they rebalance by attrition" which is certainly food for thought.

Rydex competes with the market-cap-weighted ETFs with S&P 500 Equal Weight ETF ( RSP). The underlying constituents are the exact same 500 names that are in SPY and IVV, but this ETF actively rebalances the portfolio holdings, as the market pushes them out of line. Unlike SPY or IVV, in which market forces drive the individual weightings of the securities up or down within the ETFs, RSP will rebalance the underlying index on a quarterly basis to keep all 500 members with equal weightings.

In between the quarterly rebalances, of course, RSP functions just like a free-float market-cap index, and certain names or sectors may surge while others fall, thus changing the weightings from top to bottom within the ETF between rebalance periods. Why rebalance quarterly and why equal-weight your index? If you examine the five-year trailing returns of SPY, IVV and RSP, you will see RSP truly has added alpha against the benchmark, up 2.49%, with SPY down 8.80% and IVV down 8.65% during this period. The five-year performance can be seen here.

So it seems that a regular rebalance like the RSP employs adds value, but it certainly doesn't come without cost. RSP charges 40 basis points, while SPY and IVV charge 9 basis points. I urge portfolio managers not to judge the quality of an ETF by cost alone. Instead, assess whether the ETF is designed to and has demonstrated the ability to outperform its stated benchmark. If it has, then simply factor in the expense ratio to net out this outperformance, and if you are still ahead of your benchmark, then the ETF is certainly worth further examination and consideration for your portfolios.
Paul Weisbruch is the VP of ETF/Index Sales/Trading at Street One Financial, graduating from the University of Pittsburgh, with an MBA from Villanova University. Before Street One, Paul was Director of Institutional ETF Sales at RevenueShares ETFs from December 2007 until November of 2009. Before RevenueShares, Paul was employed by Susquehanna International Group from 2000 until 2007, serving in roles including ETF Floor Specialist on the PHLX, ETF/Derivatives Intelligence, and Algorithmic Trading. Paul has been quoted in ETF industry publications including Morningstar, Traders Magazine, and Index Universe. He holds his Series 4, 6, 7, 55, 63, and 65 licenses.