This article is part of our series of regular pieces where we discuss recently issued exchange-traded products (ETPs) which are seen to be innovative or otherwise attempt to improve upon existing strategies available within an ETP wrapper. Our intention is to give the reader a better understanding of those products and highlight potential benefits and risks for investors. Last time, we examined Lyxor ETF’s EURO STOXX 50 BuyWrite.
In this article, we will analyse the first equal-weight ETFs to be introduced in Europe by Dutch provider ThinkCapital and French provider Ossiam.
Last April, ThinkCapital, a subsidiary of BinckBank, rolled out a Global Equity Tracker, which invests in 250 large cap stocks listed worldwide and a Global Real Estate Tracker, which invests in the shares of 25 real-estate firms across the globe.
This May, Natixis-owned Ossiam followed suit with the launch of an equal-weight version of three extremely popular equity indices, namely the EURO STOXX 50, STOXX Europe 600 and CAC 40 indices.
Given the relentless pace of innovation the European ETF market has seen in the past couple of years, it is actually surprising that the equal-weighting strategy wasn’t adopted earlier by European providers. The very first equal-weight ETF was launched on the other side of the Atlantic in 2003. The U.S.’s first equal weight ETF, the Rydex S&P 500 Equal Weight, today ranks amongst the 50 largest equity ETFs in the U.S. with more than $2.6 billion in assets under management. Whether the five new products issued by ThinkCapital and Ossiam will experience similar success remains to be seen.
Why Choose an Equal Weighted Index?
The main appeal of an equal weight index over a market-cap weight index is diversification. Because equally weighted equity indices attribute the same weight to each of their constituents, they provide investors with a more diversified exposure to a given stock market, avoiding concentration in a small group of large companies in the index.
Some market cap weighted indices can indeed be very top heavy from the perspective of individual names. For instance, the top 10 constituents of the EURO STOXX 50 index account for almost 39% of the index’s weighting, whereas those same stocks only represent 24.4% of the equal weighted version of the index.
The different weighting approaches also result in different sector exposures. This is due to the fact that sector weights are determined by the number of companies in each sector rather than by the market capitalisation of each company. As such, some sectors will be underweighted while others will gain weight, as illustrated by the table below showing the difference in sector weight between the EURO STOXX 50 index and EURO STOXX 50 Equal Weight Index (EWI) as of September 20, 2011.
Investors should be aware that equal weighting doesn’t necessarily reduce sector concentration. In fact, equal weighted indices could end up overweighting some already overly-represented sectors. For example, the 15 financial stocks that make up the EURO STOXX 50 index account for 26.8% of the equal weighted index’s value, while those same companies only represent 22.7% of the market cap-weighted index. By contrast, because there are only three oil & gas stocks, the energy sector has a weight of 5.9% in the equal weighted index but 9.9% in the market cap-weighted index.
When selecting an index, it is therefore important to carefully examine not only the index’s single security composition but also its sector make-up because differences in sector weight can result in different returns. Hypothetically, a strengthening financial sector and declining energy prices would benefit the performance of the EURO STOXX 50 EWI relative to the EURO STOXX 50 index.
There are several other aspects of equal-weighting that investors should consider relative to market cap-weighting.
By giving the same weight to each security on the index rebalancing date, the equal weighting approach tends to provide a tilt towards mid- and small-caps. This, in turn, means that equal weighted indices generally offer a higher risk-return profile and any outperformance is expected to derive from their more risky mid- and small-cap exposure.
This is certainly the case for the STOXX Europe 600 EWI--66% of which is comprised of mid- and small stocks. However, the EURO STOXX 50 EWI, which is exclusively made up of large caps--Alstom is the smallest stocks in the EURO STOXX 50 with a market cap of EUR 7 billion--shouldn’t be considered as a mid- to small-cap play per se, even though, by construction, it effectively benefits from a bias towards the smallest constituents in the index. Equally, Think Global Equity won’t serve as a mid- and small-cap play. Markit’s bespoke index--which the fund tracks--is made up of less than one sixth of the MSCI World’s constituents, and as such, it includes only the largest and most liquid stocks in developed regions.
In general, because smaller stocks tend to be more volatile than larger companies, equal weighted indices also tend to exhibit higher volatility, as illustrated by the graph below. A backtest run by Ossiam shows that the volatility of the STOXX Europe 600 EWI, as measured by rolling one-year annualised standard deviations, would have exceeded that of the STOXX Europe 600 index over the past 5 years although the difference in volatility decreased over that period. As expected, the difference in volatility would have been the greatest around the Lehman Brothers’ collapse and the 2009 equity market rally.
Another interesting aspect to equal weighting is that it exploits mean-reversion. When the index is rebalanced, exposure to shares which performed well is reduced while exposure to those which fared poorly is increased in order to revert to equal weight. So the methodology essentially enforces the discipline of selling high and buying low. This rebalancing strategy can help to avoid trend-following bias of market cap weighted indices and protect investors from “bubble traps”.
Total Cost of Ownership
An often cited disadvantage of the equal weighting methodology is higher turnover and frequent re-balancing, which result in additional costs. While a market cap-weighted index adjusts its composition periodically to reflect the replacement of old constituents by new constituents as a result of market capitalisation changes and corporate events, an equal weighted index must rebalance all its constituents back to the target weightings periodically. There is therefore a trade-off between the benefits of taking advantage of the short-term gains of recent winners through frequent rebalancing and turnover-related expenses.
In that regard, Think Capital and Ossiam have taken two different approaches. ThinkCapital, which uses physical replication, seeks to limit trading costs (which are not included in the TER but show up in their fund’s NAV performance) by rebalancing the holdings of its equal weighted ETFs on an annual basis. Ossiam’s equal weighted ETFs, which are synthetically replicated, are rebalanced quarterly to coincide with the quarterly share adjustments of the base indices. Now, even though synthetic ETFs typically don’t bear direct trading costs associated with index rebalancing because the index performance is delivered to the fund via the swap, they will still see their performance impacted by rebalancing-related costs. These costs will be reflected in the fees charged by the swap counterparty to the fund, which in turn will have an impact on the fund’s tracking performance.
As far as annual management fees are concerned, ThinkCapital has managed to keep costs low by resorting to Markit indices instead of using the MSCI brand. As a result, the Global Equity and Global Real Estate Trackers levy total expense ratios of only 20 and 25 bps respectively. These are about half the average TER for ETFs tracking the MSCI World and MSCI Real Estate indices. By contrast, Ossiam’s equal weighted ETFs are more expensive than their equivalent market cap weighted ETFs. For instance, the Ossiam CAC 40 Equal Weight ETF charges 5 to 10 bps more than the average CAC 40 ETF.
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