Your ETF Could Have a Fatal Flaw. Here's the Answer

Exchange-traded funds, and index mutual funds before them, were designed with a basic objective in mind: mimic the returns of popular stock market averages. The reason why funds designed to track the S&P 500 Index have attracted so much capital is because you can't find a simpler way to get stock market exposure without having to do any stock-picking or research. Buy the ETF and match the market's return.

Recently, though, the popularity of index investing has contributed to a phenomenon that ironically has made these index-tracking ETFs less effective in providing actual diversification. Because of the particular methodology that the S&P 500 and many other popular stock benchmarks use in determining how much of any given stock to buy, many of the biggest index ETFs now have surprisingly concentrated stock portfolios. For those whose entire purpose in choosing an ETF was to avoid concentration, that's a surprise.

Fortunately, there's an ETF that offers an elegant solution to the problem of concentration. Invesco S&P 500 Equal Weight ETF (NYSEMKT: RSP) avoids the problems that other S&P ETFs have with just one simple tweak to the rules most funds follow. As the Voyager Portfolio continues to look at some of the most popular ETFs in the investing universe, it's natural to turn your attention to the Invesco S&P 500 Equal Weight ETF and the advantages it has over its rivals.

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The fundamental challenge with market-cap weighting

There's an inherent attraction to using market capitalization as part of a fund's allocation methodology. The bigger a company is, the more successful its business has generally been. Larger companies have clear competitive advantages over smaller rivals, as they typically have more financial resources, giving them more capacity to make investments to further their own growth. For consumer-facing businesses, the largest companies tend to have the most brand recognition and popularity, and those intangibles often translate into a more resilient stock that can weather downturns more effectively than their smaller, weaker counterparts can. So owning more of those big companies can make it easier for a portfolio to produce dependable and consistent returns.

A problem arises when the biggest companies in the stock market all do too well for too long a time. Today, just a handful of stocks dominate major indexes like the S&P 500. Look at the top holdings of an S&P ETF like SPDR S&P 500 ETF (NYSEMKT: SPY), and you'll see that the five biggest companies are responsible for 29% of the fund's total assets.

By contrast, the median weighting of stocks in the SPDR S&P ETF is between 0.06% and 0.07%. Some of the smallest have allocations of just 0.01%. The total allocation of the bottom 250 stocks in the S&P is far below 29%, making their individual performance almost completely irrelevant to overall returns.

The simple answer for Invesco S&P 500 Equal Weight ETF

As its name suggests, the answer that Invesco S&P 500 Equal Weight came up with was to allocate its capital equally among each of the 500 or so stocks in the S&P. Price fluctuations keep the allocations from staying exactly equal, but the ETF periodically rebalances to reestablish the equal-weight equilibrium.

What that means is whether you're talking about the giant like Nvidia (NASDAQ: NVDA), a regular large-cap like FedEx (NYSE: FDX), or an up-and-coming business like Super Micro Computer (NASDAQ: SMCI), you'll have equal exposure. And so the share-price moves of any of those S&P 500 constituents have a modest but meaningful impact on your overall return.

How has the equal-weight ETF fared?

All that theory might sound good, but the real question for investors is how Invesco's equal-weight TF has performed. That's the focus of the second article in this three-part series on the Invesco ETF.

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 recommends FedEx. The Motley Fool has a disclosure policy.