Over the past several years traditional market cap weighted indexes have been derided. Why? Because upstarts, known as “smart beta” have taken the ETF marketplace by storm and are trying to dislodge traditional indexing .

And one of the oft-repeated arguments against traditional indexing that you’re guaranteed to read about or see is something like, “Market cap weighted indexes overweight overvalued large-cap stocks and underweight undervalued smaller-cap stocks.” Because of these arguments, there’s been a relentless crusade to attack the alleged imperfections of traditional indexes, which like it or not, still represent hard to beat market performance.

Funds and ETFs linked to equal-weight indexes are one example of an alternative indexing strategy that is often sold as a superior choice to traditional market cap weighted funds. Is it true?

A few months ago, I plotted the performance of the Guggenheim S&P 500 Equal Weight ETF (RSP) versus its market cap weighted cousin, the SPDR S&P 500 ETF (SPY). Here’s what I found: Since 2003, RSP gained roughly +255% compared to just a gain of just +199% for SPY. On the surface, it appears that RSP, which represents one type of “smart beta” or factor investing is the superior strategy. Is it true?

RSP takes each stock within the S&P 500 and assigns it an equal weighting of 0.20% within the index. (0.20% weight x 500 stocks = 100% allocation) This approach neutralizes the influences of larger stocks. That means smaller companies like Autodesk (ADSK), Delta Airlines (DAL), and CarMax (KMX) have the same 0.20% weighting as mega-cap stocks like Amazon.com (AMZN), Facebook (FB), and Exxon Mobil (XOM). In a traditional S&P 500 market cap weighted setting this sort of thing would never occur because only the largest stocks dominate the performance and behavior of the index. Are equal weight indexes – or for that matter – “smart beta” ETFs really bias free?

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