The meteoric rise of companies such as Facebook, Amazon, Netflix and Google parent company Alphabet (i.e., the so-called FANG stocks) means they’re commanding a larger part of market-cap weighted exchange-traded funds like the SPDR S&P 500 ETF Trust (SPY). In turn, that makes if harder for financial advisors to diversify their clients' core equity holdings via basic index-tracking ETFs.
Technology makes up 25 percent of SPY, and Apple (its inclusion in FANG turns that grouping into FAANG) is the top holding, at 3 percent. While that sounds reasonable at face value, multiply that effect across other core holdings and it could mean a portfolio is less diversified than imagined.
As Kevin Quigg, chief strategist of Exponential ETFs explained it, Apple's weighting in the S&P 500 is equal to the bottom 108 companies combined. The top 50 companies in the S&P 500 have the same market-cap weight as the rest of the 450 companies.
Although some ETFs are trying to solve the inherent problem of market-cap weighting by offering an equal-weight cap, such as the Guggenheim S&P 500 Equal Weight ETF (RSP), there's a relatively new ETF that turns market-cap weighting on its head by giving investors exposure to the S&P 500’s under-represented members.
Exponential ETFs’ Reverse Cap Weighted U.S. Large Cap Index ETF (RVRS) takes the S&P 500 and gives the highest allocation to the smallest companies and the smallest allocation to the largest companies, flipping traditional market-cap weighting, sort of like a Dogs of the Dow trade.
The methodology weights holdings by taking the inverse of their free-float market cap and divides it by the sum-total of the inverse free-float market caps. RVRS launched in November, has $3.1 million in assets under management and an expense ratio of 0.29 percent.
Its top three holdings include two energy companies, Range Resource Corp. and Newfield Exploration Co., along with Assurant Inc., a global provider of risk management solutions.
Using a reverse market-cap strategy leads to more diversification, Quigg posits.
“In the lower end of the index, there's not one company that is going take a predominant amount of market cap,” he says. “So really it just leads to more diversification because what you end up having is a lot more of your money in a lot more positions.”
The index rebalances quarterly when the S&P 500 does. If a stock’s market cap grows during the quarter, it takes up less share of the index, and if a stock’s market cap falls so much that it no longer is considered a large-cap stock, it naturally falls out of the index, he says.