After a dismal year in 2022 marked by sticky inflation and rising interest rates, the U.S. tech sector roared back to life. Led by artificial intelligence (AI) hype and positive earnings reports from notable mega-caps like Apple (NASDAQ:AAPL), Microsoft (NASDAQ:MSFT), Alphabet (NASDAQ:GOOGL) and Nvidia, major U.S. indexes staged a strong bull run.
Year-to-date as of June 12th, 2023, the benchmark S&P 500 index is up 14.23%. The large-cap tech-heavy Nasdaq 100 index has surged nearly 37% as investors clamor for exposure to its top holdings, which include all of the aforementioned companies.
Yet, some investors may be worried about concentration risk when it comes to these benchmark indexes. While historically hard to beat, there's no denying that as of recently, the performance of both has become largely driven by a select handful of mega-caps from the tech sector.
Consider the S&P 500, where Apple and Microsoft together comprise nearly 15% of the index, and the tech sector exposure sits at almost 28%. The Nasdaq 100 is even more extreme, with the two aforementioned companies sitting at around 25% and the tech sector weighing in at 50%.
There is an alternative weighting strategy, though – one that ensures a uniform distribution between different stocks. Let's take a look at the various equal-weight ETFs trading on the Canadian market.
What is an equal-weight ETF?
The majority of index ETFs used by Canadian investors tend to use the market capitalization, or market cap weighted methodology, where each stock incorporated in the index receives a weight corresponding to its market capitalization (share price times the number of outstanding shares).
As a result, stocks with larger market caps have more weight and influence on the index's overall performance. The S&P 500 is an illustrative example of such a market-cap weighted index. For example, recall that Apple currently sits at the top with a 7.51% weight.
On the other hand, an equal-weight index does away with this to instead assign identical weights to all companies within a specific index. For example, an equal-weight S&P 500 index ETF would hold a 0.20% stake in Apple, considering there are approximately 500 stocks listed in the S&P 500.
Apart from individual stocks, equal-weighted index ETFs will also generally display a more balanced distribution across the 11 various stock market sectors, market caps (small and mid-caps), and investment styles (value vs. growth).
Advantages and disadvantages of equal-weight ETFs
On the upside, equal-weight ETFs can offer better diversification by assigning the same percentage of funds to each stock in the index. This approach minimizes the risk of one or a few large companies significantly influencing the fund's performance.
There's also the possibility of better exposure to the size risk premium. This ensures that the potential success of smaller companies can better contribute to the fund's performance, leading to the possibility of superior returns if smaller companies outperform larger ones.
However, there are drawbacks to consider as well. Equal-weight ETFs often come with higher fees than market-cap weighted funds. This is largely due to the more frequent rebalancing that equal-weight ETFs require, which can increase transaction costs.
In addition, equal-weight ETFs may expose investors to greater volatility and drawdowns, especially if the index tracked includes a significant number of smaller, potentially riskier companies. While the opportunity for higher returns exists, the potential for greater losses is also present.
Some equal-weight ETFs may also be more tax-inefficient compared to their market-cap weighted counterparts due to the frequent buying and selling of shares involved in rebalancing. This could result in higher capital gains taxes for investors in taxable accounts.
There's also the debate as to whether or not a market-cap weighted approach is the "default" approach to passive indexing. After all, it makes sense that the most successful and largest companies should be held in the highest proportions. If this wasn't so, then why are market-cap indexes so hard to beat?
At the end of the day, investing in equal-weighted ETFs is a conscious decision to bet against the top market contenders of the day. Personally, I consider these ETFs a contrarian approach where investors are buying out of favor sizes, sectors, and styles. Keep this in mind before investing.
Equal-weighted ETFs to consider
Canadian investors looking for an up-to-date list of equal-weighted ETFs can use the Cboe Canada ETF Market Screener to find a number of viable options.
A popular pick that offers low fees and high diversification is the Invesco S&P 500 Equal Weight Index ETF (EQL) which currently sports $264.8 million in AUM and charges a 0.25% expense ratio. It also comes in currency-hedged ".F" and a U.S. dollar-denominated ".U" versions.
For investors looking for higher specificity, BMO (TSX:BMO) also offers a suite of equal-weight ETFs tracking a variety of sectors and geographies, such as Canadian banks, North American utilities, U.S. healthcare, and REITs to name a few.
This content was originally published by our partners at the Canadian ETF Marketplace.