The U.S. market has been soaring since the March 2009 debacle and the trend is likely to continue for another year but with bouts of volatility. The combination of factors like Trump trade, strong earnings growth, spate of upbeat economic data, and prospects of further rate hike will continue to fuel rally in the stock markets. But a series of elections and referendum in Europe, fears of political instability and geopolitical tension might weigh on the second longest bull run.

Against such a backdrop, a broad play on the stock market with cap-weighted counterparts is certainly a good option but a more targeted play could be warranted by looking at the often overlooked ‘Equal Weight ETFs’. This is because these ETFs outperform the cap-weighted counterparts over the long term (read: The Best Performing ETFs of the Bull Market Might Surprise You).

Reasons for Outperformance

Equal weight ETFs do a great job in managing single-security risk thanks to their equal allocation in the entire spectrum of market capitalization levels regardless of size. As such, it limits the risk of a severe downfall in any particular security, providing a nice balance in the portfolio. Additionally, with quarterly rebalancing, equally-weight funds tend to cash in on the overvalued segments and reinvest in the underperforming ones, potentially allowing for outperformance if the trends reverse.

Overall, these funds not only go a long way in reducing overall risk but also provide higher diversification and higher returns over the long term when compared to the market cap counterparts. Further, these offer more upside potential due to higher concentration in small and mid-cap stocks as compared to cap-weighted funds.

In fact, equal weight ETFs has proved its supremacy across all sectors in the second largest bull market. These have a minimal concentration risk, but charge a hefty expense ratio compared to the fundamentally/capitalization weighted counterpart (read: What Made Internet ETFs Outperform in the Bull Market).

Below we have compared the equal weight funds with their market cap counterparts in terms of their risk-return profiles, expenses as well as popularity since the start of the bull market:

The above table reveals that equal weight ETFs have outperformed the market cap counterparts over the long term but are relatively less popular thereby leading to lower average daily volumes and a wide bid/ask spread. This increased the total cost of trading further beyond the expense ratio. The above-mentioned equal weight ETF have an expense ratio of 0.40%, which is much higher than 0.14% for the market cap sector ETFs and 0.09% for SPY (read: Top-Ranked ETFs That Crushed S&P 500 in the Bull Market).

However, higher expense ratio and low volume do not seem to be big problems considering the solid track of equal weight ETFs. As a result, investors looking for large cap exposure should consider these products in their portfolio to avoid company specific risk and enjoy diversification benefits. Most of these ETFs have a favorable Zacks ETF Rank of 2 (Buy) or 3 (Hold) while RYU and RHS have Zacks ETF Rank of 4 (Sell) and 5 (Strong Sell).

Want to learn more about equal weighting? Check out our recent podcast on the topic below!

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