Why ETFs That Give Every Stock Equal Weight Can Be Worth a Look

 NEW YORK (TheStreet) -- Most exchange-traded stock funds favor companies with big market caps over smaller ones, a process known as cap weighting.

For example, cap-weighted S&P 500 funds will feature Apple (AAPL) as their largest holding, because Apple has the largest market cap in the world. A cap-weighted energy ETF will hold ExxonMobil (XOM) as its largest constituent because it's the largest U.S. oil company.

But cap weighting isn't always a good idea. In fact, sector ETFs that are cap weighted expose investors to excessive single-stock risk.

Remember back in 2012 when Apple tanked? That was problematic for sector funds like the Technology Select Sector SPDR (XLK), an ETF that now devotes a whopping 18% of its weight to Apple, nearly double the weight of its second-largest holding. Cap-weighted energy funds are similarly flawed as many allocate anywhere from 28% to 33% of their combined weight to ExxonMobil and Chevron (CVX).

If you want to avoid that kind of scenario, there are ETFs that attempt to give equal weight to every stock they hold. For example, a hypothetical equal-weight ETF with 100 stocks would allocate 1% to each.

Some equal-weight ETFs have outperformed their cap-weighted counterparts. The Guggenheim S&P 500 Equal Weight Technology ETF (RYT), for example, is only 1.54% Apple stock. The fund is up 4.1% so far this year, but has soared  92% over the past three years.

The cap-weighted version of the fund, which holds more Apple stock, has had a bigger gain this year, but is up 63% over three years, an impressive gain but still below the equal-weight fund.

"The composition of the nine S&P 500 sector indices can differ significantly when you compare the cap-weight version to the equal weight version," said Guggenheim Managing Director William Belden. "Some of the cap-weight indices are heavily overweighted to the mega-cap stocks in their sector."

Equal weighting is boosting the performance of some health care sector ETFs, too. Cap-weighted funds tracking this year's top-performing sector are usually heavily tilted toward Dow components Johnson & Johnson (JNJ), Pfizer (PFE) and Merck (MRK). That is not the case for the Guggenheim S&P Equal Weight Healthcare ETF (RYH)That ETF devotes just 5.3% of its combined weight to those blue-chip pharmaceuticals, but that has not stopped the fund from climbing 11.5% this year. Over the past three years, the Guggenheim S&P Equal Weight Healthcare ETF is up 129.1% compared to a gain of 121.5% for the cap-weighted Vanguard Health Care ETF (VHT).

Making RYH's performance all the more impressive is the fund's comparatively small biotech weight. While cap-weighted health care ETFs feature biotech weights in excess of 20%, that sector accounts for just 12.5% of RYH.

Investors looking for equal-weight broad market ETFs have options, too, and a new kid on the block is one of the more compelling choices.

The PowerShares Russell 1000 Equal Weight Portfolio (EQAL), which debuted in December, is an equal-weight ETF with a twist. Not only does the fund equal weight its stocks, but its sector exposures are also equally weighted. That is not common among equal-weight broad market ETFs.

Traditional equal weighting "introduces static sector biases since the weight allocated to each sector is determined solely by the number of companies in the sector," according to PowerShares. EQAL's advantages include reduced sector biases and broader diversification. The strategy is working. Since coming to market, the PowerShares funds has outpaced its traditional equal-weight and cap-weighted rivals.

This article is commentary by an independent contributor. At the time of publication, the author owned shares of Johnson & Johnson.

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