Investors have learned hard lessons about sector weightings over the years.
In 1999, for example, the S&P 500 gained 21%, thanks largely to the technology sector's 66.7% return.
That year, technology not only was hot, but its weighting in the index had swelled to almost 35%, from 10% in the mid-1990s, giving it market-moving heft.
But the tables turned. In 2000, tech was the worst performer, with a 42% decline, and was a major contributor to the S&P's 9.1% slide.
Had the technology sector of the S&P been weighted equally and not allowed to swing out of balance, the index would have gained 17.4% in 1999, instead of 21%, and it would have stayed positive in 2000 with a 2.2% gain.
Keeping weightings on an even keel is essentially the premise of the ALPS Equal Sector ETF (EQL).
Launched in July by ALPS Fund Services Inc., the fund uses exchange-traded sector funds to track the Merrill Lynch Equal Sector Weight Index.
The objective, according to Jeremy Held, ALPS' director of research, is to smooth out volatility with a core strategy that can be tweaked by using outside sector ETFs where an adviser sees fit.
“We don't want any one sector to dominate,” he said. “Sectors becoming a large part of a portfolio is even a bigger risk than individual stocks becoming a large part of a portfolio.”
Over the past 30 years, there have been three periods when the S&P 500 declined by more than 5%, and each time the index was brought down by a crash in the largest sector.
In 1981, the culprit was energy, which had ballooned during the 1970s to represent a third of the S&P.
In the three-year period from 2000 to 2002, it was technology that got overheated. And last year, the fatal sector was financials, which had grown to represent 25% of the S&P by the market's peak in October 2007.
From that point to the market's low on March 9 of this year, the financial sector had declined by 82%, while the S&P overall declined by 55%.
In 2008, when the S&P fell by 37%, financials stood out as the year's worst sector, with a 55.3% decline.
ALPS, which has $1.2 billion under management, is the first firm to offer an equal-sector-weight product, but the idea of equal weighting is not entirely new.
The Rydex S&P Equal Weight Fund (RSP) is one example of a fund that provides equally weighted exposure to every stock in the index.
This means that while the ALPS fund provides 11.1% exposure to each of nine sectors (combining technology and telecommunications into a single sector), the Rydex strategy provides 0.2% exposure to each of the 500 stocks in the index.
While the difference might seem subtle, each strategy has its unique characteristics that boil down to simple math.
By equally weighting the individual stocks, the fund is taking the same exposure to the largest company in the index (the $330 billion market-cap ExxonMobil Corp.) as it is in to the smallest ($1.2 billion Eastman Kodak Co.)
Equally weighting stocks produces an average S&P market cap of $12 billion, which is a quarter the size of the conventional S&P average market cap of $48 billion.
If the portfolio is constructed with an equal-sector weighting, the average market cap is $36 billion.
The larger average market cap leads to a lower volatility, as measured by standard deviation, but the smaller average market cap helps the fund act more like a mid-size market cap index, which can mean better performance in hotter market cycles.
On a back-tested basis, the equal-sector strategy gained 21% this year through September, compared with a 17% gain by the S&P 500 and a 35.1% return for the equal stock strategy over the same period.
Last year, when the S&P fell by 37%, and the back-tested equal-sector strategy fell by 35.4%, the equal-stock strategy fell by 40%.
E-mail Jeff Benjamin at
[email protected].
