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Montecito Capital Management, Financial Advisory Firm

Smartly’ Diversify Your Portfolio with Different ETF Methodologies

‘Smartly Diversify Your Portfolio With Different ETF Methodologies

Authored by: Montecito Capital Management

Investors need to understand that not all Exchange Traded Funds (ETFs) are created equal. Awareness of the weighting methodology of constituent stocks in ETFs is crucial for achieving low-cost equity diversification.

Understanding ETF Weighting Methodologies

Market Capitalization-Weighted Indexes (MCWI)

The most common equity index funds typically weight holdings by market capitalization—the total value of a company’s shares outstanding. For example, the S&P 500 (SPY) is a market capitalization-weighted index.

  • Calculation: Share price × number of shares outstanding.
  • Implication: MCWI tends to overweight expensive stocks and underweight cheaper stocks.
  • Rationale: Some argue this is appropriate since best-performing stocks should continue growing without higher transaction costs or tax friction from frequent turnover.

Equal-Weighted Indexes (EWI)

EWI treats all stocks equally in weighting allocation, underweighting large stocks while overweighting smaller ones.

  • Example: S&P 500 Equal Weight Index is rebalanced quarterly.
  • Turnover: Over the past decade, the average annual turnover for EWI has been ~25%, higher than the MCWI’s 6%.
  • Impact: EWI weightings are not correlated with expected returns, have lower sector concentration, but face higher liquidity constraints.

Comparison Example:

  • Top 10 S&P 500 MCWI stocks = ~16% of index
  • Top 10 S&P 500 EWI stocks = ~2% of index
  • Leading EWI ETF: Guggenheim S&P 500 Equal Weight ETF (RSP)
  • Performance: As of June 30, 2014, RSP averaged +10.1% annual return, versus SPY’s +7.7%.

Sector Exposure Differences

EWI offers broad diversification across market segments, reducing concentration risk.

  • EWI is typically overweight in materials, consumer discretionary, and utilities.
  • EWI is typically underweight in energy, health care, and telecommunication services compared to MCWI.

Performance Comparison: EWI vs. MCWI

Historical Outperformance

  • EWI has a small-cap bias, outperforming when smaller stocks exceed larger stocks in performance.

  • Example: 2009: EWI +45% vs. MCWI +26%.

  • 20-year period ending 2012: EWI outperformed MCWI by +2.0% annually.

Volatility Considerations

  • EWI tends to have higher risk, measured by volatility or standard deviation.

  • 5-year period ending 2007: Standard deviation: EWI 10.97% vs. MCWI 8.61%.

Complementary Approach

Holding both EWI and MCWI can smooth portfolio performance:

  • Tech bubble 2000-2006: MCWI +1% vs. EWI +9.1%

  • 1995-1999: MCWI +29% vs. EWI +21%

Using ETFs Strategically

Investors can time ETF allocation based on market cycles:

  • MCWI for growth periods
  • EWI for value-oriented periods


Alternatively, style-specific ETFs like large growth (RPG) or small cap value (VBR) can complement a portfolio but may reduce overall diversity.

Beyond MCWI and EWI: Smart Beta ETFs

What is Smart Beta?

Smart beta combines active selection strategies with passive management, weighting holdings using fundamental metrics instead of market cap.

  • Examples:

    • Large-cap: PowerShares FTSE RAFI U.S. 1000 (PRF)

    • Mid-cap: WisdomTree MidCap Earnings (EZM)

    • Small-cap: RevenueShares Small Cap (RWJ), WisdomTree SmallCap Dividend (DES)

  • PRF weights holdings by book value, cash flow, sales, and dividends rather than market cap.

  • Smart beta ETFs can outperform traditional ETFs but may have higher costs.

Performance of Mixed ETF Portfolios

  • 3-ETF portfolio (1/3 allocation each to SPY, RSP, PRF):

    • 9/25/08–9/25/14 CAGR = +12.3% vs. SPY alone +10.8%

  • 5-ETF portfolio (1/5 allocation to SPY, RSP, PRF, RWJ, EZM):

    • CAGR = +13.0% vs. SPY alone +10.8%

    • 2009: SPY +26.4% vs. 5-ETF portfolio +41.7%

Key Takeaways

  • Diversify ETF methodologies to replicate broad indexes and reduce portfolio risk.
  • Consider alternatives to large-cap weighted ETFs to enhance diversity and risk-adjusted returns.
  • Smart beta ETFs are emerging and promising, but involve higher costs.
  • ETF methodology diversity is crucial for low-cost, efficient portfolio indexing.
  • Image Suggestion: Infographic summarizing ETF methodologies and their benefits.