Equal weight investing refers to assigning equal weights to each constituent in an investment portfolio, rather than weighting based on market capitalization like traditional market-cap weighted indexes. Some examples of popular equal weight index funds and ETFs include the Invesco S&P 500 Equal Weight ETF (RSP), Guggenheim S&P 500 Equal Weight ETF (RSP), and First Trust Nasdaq-100 Equal Weighted Index Fund (QQEW).
More diversification and reduced concentration risk
Compared to market-cap weighted indexes that are highly concentrated in a few mega-cap stocks, equal weight indexes provide more diversification across the full spectrum of market-cap. For example, in a market-cap weighted S&P 500 index, the top 10 largest stocks account for over 25% of the portfolio. But in an equal weight S&P 500 index, each stock represents only 0.2% initially. This avoids excessive concentration risk.
Lower volatility and smaller drawdowns historically
Research shows that equal weighting has resulted in lower volatility and smaller max drawdowns compared to the market-cap weighted S&P 500 over extended periods. This is because equal weighting mechanically rebalances into out of favor, cheaper sectors, providing a contrarian bias.
Potential for higher returns in certain environments
During periods when smaller cap stocks outperform (like early cycle recoveries or economic expansions), equal weight indexes can benefit from their constant tilt towards small and mid-caps. If this factor premia persists, it may lead to long-term outperformance.
Cap weighting has also done very well over long term
However, despite periodic spurts of outperformance, equal weighting has failed to consistently outperform over most extended periods. The market-cap weighted S&P 500 index has still done very well over long horizons thanks to the strong performance of mega-cap leaders like Apple and Microsoft.
Higher turnover and trading costs
Equal weighting requires periodically rebalancing back to equal weights when positions drift. This reconstitution and rebalancing can result in higher turnover and trading costs compared to traditional cap weighted indexes.
In summary, while equal weight indexing provides benefits like diversification and contrarian exposures, cap weighting has also performed strongly over long periods. Investors should analyze their portfolio construction goals, return expectations and risk tolerances when deciding between the two approaches.