Friday, September 28, 2007

Equal weight ETFs

Yesterday I explored a new (to me) ETF called the Rydex S&P Equal Weight ETF (AMEX:RSP). The idea is that instead of representing the underlying companies proportionally to their market capitalization, each one is represented, well, equally.

Looking at RSP vs. SPY, the most famous S&P 500 ETF, there are a few things I immediately like. There is a bit less weight given to financial companies in RSP, which is good because at this point I don't really want to invest in them. SPY, on the other hand, has among its top 5 holdings both Bank of America and Citigroup. There's more weight given to sectors I like, such as consumer goods and services, industrials, and basic materials.

Consumer goods is a great sector to invest in right now given the downward spiral of our economy. We should be looking at recession-resistant companies. Consumer goods companies like Procter & Gamble sell essential products like soap and detergent that people buy regardless of how the economy is doing.

I like industrials and basic materials for a different reason -- globalization. Every day, some news comes out about GE's overseas deals. They're building locomotive factories in India, selling jet engines to Dubai, partnering with Japanese companies to build nuclear reactors, selling special furnaces to Chinese steel companies, and on and on. According to GE's Citizenship Report (silly term heh), more than half of their revenue will come from overseas this year. Large industrial companies in the US are in a great position to earn massive amounts of money overseas, especially with the falling dollar. And again with the falling dollar, basic materials companies will find it easier to compete with imports, as well as become more attractive overseas.

Aside from sector allocation, perhaps the best thing about RSP is that their reallocation strategy is more correct. Say a company has a great year and its market cap increases 50% (yay!). SPY will buy more of the company because now it represents a bigger piece of the S&P 500 pie. If the next year the stock goes down a bit, SPY will sell shares. Buy high, sell low -- doesn't sound like a winning strategy!

RSP, on the other hand, will behave better. If the stock goes up, RSP sells shares because it ignores market cap and looks at a fixed percentage. In other words, every company should represent 0.2% (1/500) of the total fund. If a company doubles, it will be above its allotted 0.2%, so they sell shares to bring it back down. Then if the company drops a bit, it will fall below 0.2% and they will buy shares. Buy low, sell high, just what we want to hear.

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