Will Invesco S&P 500 Equal Weight ETF Finally Reward Patient Investors?

You often see the cutting edge of financial innovation in the latest trends in the exchange-traded fund universe. Whenever someone sees a potential new angle on a successful investment, it likely that a new ETF will appear to give investors a taste. That's what initially happened with the Invesco S&P 500 Equal Weight ETF (NYSEMKT: RSP), which was designed to take advantage of potentially market-beating returns from weighting the smaller companies in the S&P 500 the same as the larger companies.

To date, though, equal-weight ETFs like the Invesco fund haven't really delivered on their promise. Returns have lagged behind ordinary S&P 500 index funds, making the slightly higher expense ratio that the Invesco ETF charges seem like a waste. Yet many patient investors believe that it's too early to count equal-weight ETFs out entirely. In this third and final article about Invesco S&P 500 Equal Weight ETF for the Voyager Portfolio, you'll find out the arguments for and against rosier expectations ahead for the fund.

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The pros and cons of concentration

The primary factor that determines how the Invesco S&P 500 Equal Weight ETF relative to the S&P 500 is how the largest, most highly weighted companies perform. When Nvidia (NASDAQ: NVDA) represents roughly 0.2% of the Invesco ETF but over 7% of the market-cap-weighted S&P 500, how the chipmaker performs makes a huge difference.

When those large tera-cap stocks are moving consistently higher, it puts the Invesco ETF at a disadvantage. Nvidia made up less than 1% of the S&P 500 as recently as just a few years ago, but as it soared, the index made no adjustment to its holdings. By contrast, every time the Invesco ETF rebalanced its portfolio, it reduced Nvidia's stake in the fund back to 0.2%. Subsequent gains got diminished in the equal-weight ETF as a result, while the S&P 500 enjoyed every penny of Nvidia's ascent.

When markets oscillate

Equal-weight ETFs do better under more typical market conditions, when stocks rise and fall more regularly. Essentially, what the equal-weight ETF's rebalancing does is sell off short-term winners and reallocate the proceeds into the weaker-performing short-term losers. When investors are regularly rotating out of highly popular, highly valued sectors of the market into more out-of-favor, reasonably priced sectors, it plays directly to the strengths of the equal-weight ETF strategy.

The recent swoon in software stocks led to a renewed level of interest in the Invesco S&P 500 Equal Weight ETF and similar funds. That's because equal-weight ETFs outperformed their market-cap-weighted counterparts, and also, equal-weight ETFs will end up allocating money back into those stocks at more attractive prices at the next rebalancing.

Until the weighting differential between the S&P 500 and the Invesco ETF narrows, though, the relative performance of tech stocks will keep determining whether equal-weight ETFs outperform or underperform the index. Over time, it's possible that S&P Dow Jones Indices will include a greater number of tech stocks in the S&P 500, which of course would boost the sector's overall weighting in the equal-weight ETF. Still, it's more likely that a tech-sector pullback will be the key factor that decreases the weighting disparity.

Be smart with your stock exposure

I won't be buying shares of the Invesco S&P 500 Equal Weight ETF for the Voyager Portfolio, but I do own shares in other accounts. Even though it hasn't performed as well as hoped, the Invesco ETF still serves a valuable function in diversifying my overall portfolio. In an investing environment in which many investors have large allocations to technology stocks, the more cautious approach represented by the Invesco ETF carries a certain appeal. And if a tech swoon ever happens, you can expect the Invesco ETF to see much larger gains.

Dan Caplinger has positions in Invesco S&P 500 Equal Weight ETF and Nvidia. The Motley Fool has positions in and recommends Nvidia. The Motley Fool has a disclosure policy.