The Lure of Apple-Light ETFs

The terrible performance of Apple over the past six months hasn't just hurt its shareholders. Just about anyone who invests in any sort of index fund has felt the pain of Apple's 40% correction, given the tech giant's status as the biggest company in the U.S. stock market.

When one stock can have such a huge impact on what's supposed to be a diversified investment vehicle, it's tempting to conclude that there's something flawed about that investment's methodology. Apple's losses are a big part of the reason that investors are taking a close look at equal-weight ETFs to see if they can deliver better returns with less risk.

Hitting the big ETFs
It's not hard to find proof of just how damaging Apple's plunge has been. The popular PowerShares QQQ , which tracks the Nasdaq 100 index, has fallen 1.3% in the past six months since Apple hit its all-time high above $700 per share. That compares to an 8% gain for the S&P 500 -- despite Apple's sizable weighting in that index -- and a similar gain of 7% for the Apple-free Dow Jones Industrials excluding dividends.

You can see another sign of the massive hit that Apple has had on the index by looking at the Direxion Nasdaq-100 Equal-Weight ETF, which has gained more than 9% since last September. In that ETF, Apple has only a 1% weighting rather than the 13% weight that the tech giant has in the PowerShares ETF.

Proponents of equal-weight funds argue that this proves the validity of their strategy. Rather than taking market capitalization into account in buying more of some stocks than others, equal-weight funds simply buy equal amounts of every stock in an index. The result is a truly diversified portfolio that gets rebalanced regularly to incorporate changes in share price.

Over the long haul, the equal-weight strategy has worked very well. Given the relative outperformance of smaller, more volatile stocks compared to their larger counterparts, equal-weight funds have benefited from having greater weight on smaller stocks and less exposure to lagging blue chips. Although ETFs using the strategy have relatively short histories, similar equal-weight traditional mutual funds have histories going back 10 to 15 years, and they've tended to outperform the market-cap-weighted S&P 500 by 2 to 3 percentage points annually -- a huge amount to see year in and year out.

A better alternative?
Interestingly, because equal-weight S&P 500 funds take away the vast majority of the weighting from the component stocks with the largest market caps, they tend to perform in line with mid-cap funds that only include stocks of similar size to the smallest stocks in the S&P 500. In fact, if you look at the returns for the S&P Mid-Cap 400 ETF over the same 10- to 15-year time frame, you'll find that it outperforms the S&P 500 by an even larger margin than equal-weight funds. Yet as a Zacks report cited in Barron's noted recently, you'll end up paying a lot more in expenses for the typical equal-weight fund.

Why that is is a completely mystery. There couldn't be anything easier than buying equal amounts of 500 different stocks, yet for some reason, equal-weight ETFs charge four to eight times what you'll pay for the cheapest S&P 500-tracking index ETFs. Yet until a low-priced ETF provider comes out with an equal-weight option, you'll be better off sticking with a mix of cheaper ETFs, with one covering large caps and others covering mid-cap and small-cap stocks.

Keeping your eyes on the prize
Despite their long-term outperformance, equal-weight ETFs are subject to the same cycles that dominate financial markets generally. They move in and out of favor compared to market-cap-weighted ETFs, sometimes outperforming, sometimes underperforming. Apple's influence has helped equal-weight ETFs lately, but that's not cause to abandon market-cap weighting entirely. No matter what ETF you pick, the key is for it to give you the stock exposure you want at a reasonably low price.

Apple has crushed shareholders and ETF investors lately, but with shares so cheap, value investors are wondering whether Apple is a screaming buy. Let Motley Fool senior technology analyst and managing bureau chief Eric Bleeker fill you in on both reasons to buy and reasons to sell Apple, and what opportunities are left for the company (and your portfolio) going forward. To get instant access to his latest thinking on Apple, simply click here now.

The article The Lure of Apple-Light ETFs originally appeared on Fool.com.

Fool contributor Dan Caplinger owns shares of Apple. You can follow him on Twitter @DanCaplinger. The Motley Fool recommends Apple. The Motley Fool owns shares of Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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