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Equal-Weight ETFs Leading Latest Market Rally: Here's Why

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The U.S. market has been skyrocketing to new highs lately on an encouraging development in coronavirus vaccines that has raised investors’ risk appetite.

Markets are betting on economic recovery given the potential for distribution of vaccine anytime soon. A slew of encouraging trial data from AstraZeneca (AZN - Free Report) , Moderna (MRNA - Free Report) and Pfizer (PFE - Free Report) has pushed the prospect of vaccination as early as this month with UK being the first country to approve the same.

Additionally, the potential for a divided Congress with President-elect Biden have added to the strength. The divided government is favorable for the economy, as there will be lesser chances of major tax increases and tighter regulations. The prospect of a smooth transition of Biden to the White House has also been driving the stocks higher. The combination of factors will continue to drive the stocks higher as we move toward next year (read: 5 ETFs at the Forefront of the Latest Market Rally).

Further, the stocks are poised to reap benefits of massive cheap money flowing into the economy, along with an anticipated additional round of fiscal stimulus. Lower interest rates will continue to fuel the economy, leading to higher spending power.

While the rally has been broad-based, equal-weighted ETFs are outperforming their cap-weighted peers. This is especially true as Invesco S&P 500 Equal Weight ETF (RSP - Free Report) , Invesco S&P MidCap 400 Equal Weight ETF (EWMC - Free Report) and Invesco S&P SmallCap 600 Equal Weight ETF (EWSC - Free Report) delivered returns of 6.4%, 8.9% and 14.4%, respectively, in a month. In comparison, cap-weight ETFs — SPDR S&P 500 ETF (SPY - Free Report) , SPDR S&P MidCap 400 ETF (MDY - Free Report) and SPDR S&P 600 Small Cap ETF (SLY - Free Report) — have gained 4.1%, 7.4% and 11.6%, respectively (read: Small-Cap ETFs Face Off: IWM Vs. IJR).

The outperformance is likely to continue given the same trend persists.

Equal-Weight ETFs in Focus

These equal-weight ETFs are relatively less popular thereby leading to lower average daily volumes and a wide bid/ask spread compared to market-cap cousins. This increased the total cost of trading beyond the expense ratio. Additionally, these funds charge a hefty expense ratio compared to the fundamentally/capitalization weighted counterpart (RSP – 0.20% vs. SPY – 0.09%, EWMC – 0.40% vs. MDY – 0.23%, EWSC – 0.40% vs. SLY - 0.15%).

Though these ETFs have higher expense ratio and low trading volume, these do not seem to be big problems as the products avoid company-specific risk and enjoy diversification benefits.

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. The best thing about this approach is that performance is not heavily dependent on the returns in a particular stock or group of securities (read: 5 Sector ETFs That Beat the Market in November).

Additionally, with quarterly rebalancing, equal-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. In fact, equal-weight ETFs has proved its supremacy across all sectors over the longer term. These have minimal concentration risk.

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