ETFs Offer Eight Ways to Weight the Same Stocks

ETFs are a big help in many ways. One of the top benefits is that you are relieved from the task of deciding which individual stocks to buy out of the thousands available. Stock-picking is tough business.

What you may not know is that building a list of stocks is only part of the work. You also have to decide how much of your portfolio you will allocate to each one. Professionals call this a weighting strategy — and it is crucial to your long-term success.

Today we’ll look at some common weighting strategies and see what a difference they can make in your bottom line.

Weighty Matters!

I’m going to illustrate my point by looking at the U.S. large-capitalization stock market — the big companies that constitute most of the trading activity.

Analysts have different definitions of just what should be considered “large.” The most common is the S&P 500 Index. The 500 stocks picked by S&P are well-known to everyone. Both institutional and individual investors use the index as a benchmark. Any domestic fund that calls itself “large cap” probably has most of the same stocks as the S&P 500.

You can, however, combine this particular group of stocks in various ways. Consider the following list of ETFs. All are based, more or less, on the stocks in the S&P 500 Index. Yet look at the three-year cumulative performance difference (as of 4/21/11):

WisdomTree LargeCap Dividend (DLN) -1.1 percent

WisdomTree Earnings 500 (EPS) +2.2 percent

SPDR S&P 500 (SPY) +3.1 percent

PowerShares Dynamic Large Cap (PJF) +4.0 percent

RevenueShares Large Cap (RWL) +4.2 percent

PowerShares FTSE RAFI U.S. 1000 Portfolio (PRF) +15.1 percent

First Trust Large Cap Core AlphaDEX (FEX) +15.4 percent

Rydex S&P 500 Equal Weight (RSP) +18.6 percent

As you can see, even ETFs that generally hold the same group of stocks can have dramatic performance variation. Over the last three years, the best in the group made +18.6 percent while the worst lost 1.1 percent.

Why is this? Expenses may account for a very small part of the gap, but I think weighting is the bigger issue. Every ETF on this list employs a different weighting strategy …

• DLN, which had the worst three-year results, gives more weight to stocks that pay high, consistent dividends. That didn’t work so well in the last few years because the financial crisis forced many companies — particularly banks — to actually cut their dividends.
• EPS also comes from WisdomTree. This one allocates its money across large-cap stocks according to their corporate earnings. As it turns out, that approach produced results nearly identical to the S&P 500 during the past three years.
• SPY, the defacto standard for S&P 500 ETFs, of course uses the traditional approach of weighting the 500 stocks by market capitalization. The 10 largest holdings occupy 18.8 percent of the fund while the 10 smallest ones have less than a 0.2 percent allocation.
• PJF uses an “intellidex” methodology to pick the large-cap stocks with the greatest potential for price appreciation. Apparently PowerShares is not satisfied with the results — earlier this month they announced plans to change this ETF’s benchmark index, ticker symbol, and investment strategy. Starting June 16, it will look much more like PRF.
• PRF is another large-cap ETF from Powershares. This one is based on the Research Affiliates Fundamental Index (RAFI) methodology and holds 1,000 stocks weighted by a score consisting of their book value, cash flow, sales, and dividends. Higher-scoring stocks get bigger allocations.
• RWL comes from RevenueShares, and not surprisingly bases its holdings on revenue. Companies that bring in more money get a bigger slice of RWL.
• FEX follows an “enhanced” (AlphaDEX) index that ranks stocks according to fundamental criteria like sales growth and cash flow. The higher-ranked companies get a bigger weighting in FEX, and the lowest-ranked 25 percent get a 0 percent weighting.
• RSP holds the same stocks as the S&P 500, but in equal allocations. Each stock gets the same 0.2 percent of the portfolio at each periodic rebalancing.

Your next question, of course, is probably “Which way is best?” The answer depends on your goals. If you want your portfolio to look like “the market” and don’t expect outperformance, then SPY is what you need. If you want the potential to do better than the S&P 500, then it may be time to look at one of the alternative-weighting ETFs.

The data show that RSP had the best performance over the last three years. We don’t know about the next three years. Maybe investors will start to demand dividends and DLN will shine. Any one of these ETFs could become the top performer. It all depends on the market conditions we encounter and the approach that is best suited for those conditions.

You also don’t want to forget about risk. Some of these ETFs are more volatile than others. Think about that if you don’t like roller-coasters.

Best wishes,

Ron