The Benefits of Equal Weighting | ITEK
Indices are some of the most powerful and useful tools for the modern investor- both as a benchmark for performance and as a foundation for the creation of ETFs, index funds and derivatives. Tens of trillions of investment dollars are managed or benchmarked against indices, making their construction, management and constitution incredibly important.
Indexes are really just recipes – they tell the market what ingredients (companies) to include and how much (weighting) of the ingredient to use to come up with the right dish. If you change the recipe or ingredients, then you change the way the dish ends up.
The majority of the main ‘headlines’ indices (think FTSE 100, S&P 500 or DAX) weight their constituents by market capitalisation (price x free float shares). For example, a company with a market cap of $100Bn will have 20x the index weight of a company with a $5Bn market cap.
Weighting by market capitalisation is now the most commonplace approach for most equity indices, but this has not always been the case. The very first index (the Dow Jones Transportation Average – invented in 1884) weighted each component equally, regardless of their capitalisation. While market cap is still the most commonly used approach in equity indices, equal weighting has enjoyed somewhat of a renaissance in recent years, as investors sought out uncorrelated or ‘alternative’ beta exposures.
The HAN-GINS Innovative Technologies UCITS ETF (ITEK) applies an equal weight methodology, but what are the advantages of equal weight and why does it make sense to use this approach?
The HAN-GINS Innovative Technologies UCITS ETF (ITEK) offers exposure to eight transformational technology themes. including Robotics and AI, Cloud Computing & Big Data, Cyber Security, Future Cars, Genomics, Social Media, Blockchain, Augmented & Virtual Reality.
We believe that these themes best capture one of the most significant economic, social and investment megatrends of our time - what the World Economic Forum describes as The Fourth Industrial Revolution: (1)
"In its scale, scope, and complexity, the transformation will be unlike anything humankind has experienced before… The possibilities of billions of people connected by mobile devices, with unprecedented processing power, storage capacity, and access to knowledge, are unlimited. And these possibilities will be multiplied by emerging technology breakthroughs in fields such as artificial intelligence, robotics, the Internet of Things, autonomous vehicles, 3-D printing, nanotechnology, biotechnology, materials science, energy storage, and quantum computing.”
ITEK combines these themes into a single ETF but instead of weighting by market cap, ITEK weights each theme equally and also equally weights the constituent companies within each theme. We call this a ‘double diversification’ approach, but why does this make sense?
Price & Weight: Why Break the Link?
The benefits of an equal weight approach, relative to traditional market cap revolve around how the new ‘recipe’ changes the factor exposures of the index – the qualities that influence and explain the performance of securities and indices.
Having more allocation to smaller companies offers the investor a chance to outperform the cap-weighted benchmark index by increasing exposure to the ‘size premium’ – the idea that over time, smaller stocks generally outperform larger stocks.
If the result of weighting by market capitalisation is larger companies take up a larger portion of the overall index, then the reverse is true for equal weight indices - smaller companies take up a larger portion of the overall index - and offer greater size premium exposure.
An example is the FTSE 100 which on a market capitalisation basis sees the top 10 largest constituents take up nearly 45% of the total index, with the largest (Astra Zeneca) representing 7.3% of the total weight. (2)
In an equal weight index the top ten would instead be just 10% of the overall exposure and Astra Zeneca would have a 1% weight. So, with a market capitalisation approach, investors who want diversification may discover they are more highly concentrated in a few big names than they wanted.
While equal weighting can add as a powerful diversification tool at the constituent level it should also be noted that it can also alter the sector, country and currency exposures relative to the benchmark. As this will vary from index to index, the investor should look carefully at the relevant data.
Equal Weight is Easy
A further benefit of equal weighting is that it is a simple and straightforward. Amidst an array of esoteric index approaches like fundamental, low volatility, low beta, minimum variance or volatility targeting; equal weight stands out as easy to ‘get’, while appealing to the idea of fairness and a level playing field.
Face the Future
As market cap indices were originally designed to be measurement tools to gauge the performance of asset classes, markets or sectors, they naturally reflect the past and what has happened to the market they track. But backing yesterday’s winners may not be the best approach when the goal is to give investors exposure to innovative themes that are shaping the future.
Equal weighting constituents avoids staking implicit bets on the companies that are currently the largest and, since many of the companies driving change are smaller, disruptive players, it ensures that each company is given equal opportunity to contribute to the overall index performance and decreases the risk of a large underperforming constituent dragging down the index as a whole.
Equal weighting also makes sense at a sector level when considering nascent, high-growth sectors that are interrelated and, in many cases, mutually supportive.
This is very much the case in the ITEK sectors where, for example, the growth of future transport theme is linked to developments in other themes like cloud computing, cyber security, big data, robotics and augmented reality. Equal weighting at the sector level therefore positions ITEK to capture growth wherever it occurs, rather than taking a position on an individual sector. This is particularly important as the individual sectors perform differently year-to-year. It’s hard to predict which of the sectors will be the best performer in any given year and so it makes sense to diversify equally across each sector.
(based on Sharpe Ratio) 2015 2016 2017 2018 2019 2020 ytd 2015 – 2020 ytd
1 Health & Biotech 1 Robotics 1 Robotics 1 Cyber Security Fintech Health & Biotech 2 Robotics 2
2 Health & Biotech 2 Robotics 2 Robotics 2 Fintech Cloud &
Digital 1 Health & Biotech 1 Cloud & Digital 10.7
3 Cars & Battery 2 Cars &
Battery 1 ITEK Cloud &
Digital 1 Cloud &
Digital 2 Cloud &
Digital 1 ITEK
4 Fintech Cloud &
Digital 1 Health & Biotech 1 Health & Biotech 1 Robotics 2 ITEK Fintech
5 ITEK Fintech Cars &
Battery 1 Health & Biotech 2 ITEK Cyber Security Health & Biotech 1
6 Cloud &
Digital 1 ITEK Cloud &
Digital 2 Cloud &
Digital 2 Robotics 1 Robotics 2 Cyber Security
7 Cars &
Battery 1 Cars &
Battery 2 Cars &
Battery 2 Robotics 2 Cyber Security Cars &
Battery 2 Health & Biotech 2
8 Cloud &
Digital 2 Cloud &
Digital 2 Fintech ITEK Cars &
Battery 2 Fintech Robotics 1
9 Robotics 2 Cyber Security Cloud &
Digital 1 Robotics 1 Cars &
Battery 1 Cloud &
Digital 2 Cars &
10 Cyber Security Health & Biotech 1 Health & Biotech 2 Cars &
Battery 2 Health & Biotech 1 Robotics 1 Cloud &
11 Robotics 1 Health & Biotech 2 Cyber Security Cars &
Battery 1 Health & Biotech 2 Cars &
Battery 1 Cars & Battery 1
For illustrative purposes only.
As the very first index was equally weighted, there is a degree of irony applying this methodology to an index and ETF that targets some of the most advanced companies in the world. Yet, from pervasive social media, to cloud-based remote working, smart phones, ecommerce and electric cars the effects of the fourth industrial revolution are already being seen in our day-to-day lives and are likely to evolve even faster and further in coming years. By taking an equal-weight ‘double diversification’ approach across eight of the most important industry 4.0 sectors, ITEK delivers real diversification on a global level to the companies poised to change our world combined with the potential for long-term outperformance from additional exposure to the size factor.
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