In yesterday’s post I looked at the recently launched BMO Equal Weight REITs (ZRE), which invests in Canadian real estate investment trusts. The new ETF is going head-to-head with the iShares S&P/TSX Capped REIT (XRE), which until now had no competition in this space. The big difference between the two funds is that ZRE is equal-weighted, while XRE uses traditional cap-weighting. So, which strategy is superior?
There’s no question that cap-weighted indexes have a flaw: because they are heavily influenced by each stock’s current share price, they give greater weight to overvalued companies and less to undervalued ones. That makes them prone to bubbles: for example, when the price of Internet stocks rose to absurd heights in the 1990s, technology companies dominated the S&P 500, even though some of these had never actually made any money. Meanwhile, fundamentally sound but undervalued companies made up a smaller and smaller portion of the index. We all know what happened next.
In recent years, a number of index providers have looked for ways to avoid this Achilles heel of cap-weighting. Perhaps the best-known “price-neutral” strategy is fundamental weighting,