Equal Weight ETFs: Favoring Smaller Cap Holdings Could Be Key

Every now and again the debate of equal-weight vs. market capitalization-weight ETFs (exchange traded funds) takes center stage. Depending on who you talk to, one is often cited as being better than the other. I disagree. Both styles provide different investments. So maybe one is better for YOU, but there isn't one style that is better for EVERYONE.

First off, let me describe the differences. ETFs need to determine how much of each constituent company to hold. This is more often than not based on the company's market capitalization. The greater a company's market capitalization, the greater the percentage of the ETFs holdings it will represent. With equal-weight ETFs, every company is allotted an equal percentage of the ETF. This means that a large company such as Microsoft won't have any more influence on the ETF than a small company like RSA Security Inc.

Some people point to the recent performance of equal-weight ETFs as proof that they are superior. But this logic is flawed. The main reason that equal-weight ETFs have done better is that their structure favors smaller capitalization stocks which have done better across the board. Currently, megacaps are “out of favor” and are lagging the market. But one day these larger companies will become the leaders in terms of returns and at this time the ETFs that emphasize these through market capitalization will pull ahead of the equal-weight ETFs.

So the choice of which type of ETF to use depends largely on what else you have in your portfolio. I prefer to use the smallcap ETFs to get my smallcap exposure rather than to figure out how to use an equal weight ETF to achieve the same effect.