Cap-weighted vs. equal-weighted ETFs: Which is best for Canadian investors?

The CAPE Ratio assesses a inventory’s worth in comparison with its common earnings over the previous 10 years, adjusted for inflation. A excessive CAPE Ratio means that shares could be overvalued relative to historic earnings, indicating potential draw back dangers.

The image isn’t as clear-cut because it appears, nevertheless. One of many main drawbacks of equal weighting, as critics level out, is the extra drag on efficiency from its methodology. 

Take the Invesco S&P 500 Equal Weight ETF (RSP) for example. It has a 21% turnover and a 0.20% expense ratio. The Canadian-listed model is the Invesco S&P 500 Equal Weight Index ETF (EQL, EQL.F). In distinction, SPY maintains a mere 2% turnover and a decrease expense ratio of 0.0945%.

Whereas it’s true that RSP outperformed SPY in whole returns since its inception in April 2003, the victory isn’t as clear-cut because it may appear. The chance-adjusted return of RSP, indicated by a Sharpe ratio of 0.45, is barely decrease than SPY’s 0.48. What does that imply? It might recommend that RSP took on greater volatility for less than marginally higher returns. Furthermore, RSP skilled a deeper most drawdown than SPY. A most drawdown measures the most important single drop from peak to trough throughout a specified interval, indicating a better historic danger of losses for buyers.

Additional evaluation through issue regression reveals that almost all of RSP’s outperformance could be attributed to the dimensions. Basically, RSP’s equal-weighted methodology has inadvertently skewed its publicity in the direction of smaller and extra undervalued corporations, which traditionally have contributed to outperformance.

This raises a important level: If the objective is to put money into these sorts of corporations, wouldn’t it’s extra easy and environment friendly to focus on them straight based mostly on basic metrics quite than adopting a blanket equal-weighting method to your entire S&P 500?

I discover myself siding with cap weighting now. The first attraction is simplicity. Market-cap methods require fewer selections relating to rebalancing or reconstitution, which in flip retains sources of friction like turnover and charges significantly decrease—leading to fewer headwinds to efficiency.

In a super frictionless world, the attraction of equal weighting is evident. Nonetheless, the fact of quarterly rebalancing and better charges related to equal-weight ETFs has not traditionally yielded higher risk-adjusted returns over the past 20 years.