The recently launched BMO Equal Weight REITs (ZRE), which invests in Canadian real estate investment trusts, will go 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, which is based on a company’s dividends, free cash flow, total sales and book value. This is the strategy Claymore uses in its most popular equity ETFs.

Another alternative strategy is equal weighting, or assigning the same fixed allocation to every stock in the index. A number of BMO’s new ETFs use this strategy, including ZRE, which includes 17 real estate investment trusts, each of which makes up about 6% of the fund’s holdings. In contrast, the cap-weighted iShares fund assigns 25% to its largest holding (RioCan) and less than 4% to its smallest.

Many commentators seem to take it for granted that XRE’s top-heavy index is a problem. But my first reaction is that we don’t apply that logic to other indexes. If you buy a cap-weighted Canadian equity index fund, you’re investing 30% of your money in the financial sector and just 3% in consumer staples. A European index fund has about 32% of its holdings in the United Kingdom and 2% in Finland. That simply reflects the economic reality, and few people would argue that we should weight sectors or countries equally.

By the same logic, if RioCan represents 25% of the REIT economy in Canada, why should it not represent a similar amount of the index? RioCan’s market cap is almost $4.8 billion, compared with Artis REIT’s $480 million. Why is it a sound strategy to invest equal amounts in both companies (as BMO’s REIT fund does) when one is ten times larger?

In some ways, criticizing an index for overweighting large companies is like suggesting that Canadian democracy is problematic because Ontario’s voters have more influence than Prince Edward Island’s. In fact, I’d make the opposite argument: by giving all the premiers an “equal weighted” position at First Ministers’ conferences, the 140,000 residents of PEI have a representation that is way out of proportion. This kind of distortion occurs in the Rydex S&P Equal Weight ETF (RSP), which holds all the companies in the S&P 500 and assigns each one a weight of 0.2%. In this index, Exxon Mobil has the same influence as Office Depot, even though the former is a hundred times larger.

If traditional indexes give too much weight to large or overvalued companies, equal-weight indexes are biased toward small-cap stocks, sometimes dramatically. They also overweight sectors that are made up of many small companies (like consumer discretionary) and underweight those dominated by a few large players (like utilities and energy). If you believe in efficient markets — and if you don’t, you’re not an index investor — then equal weighting is hard to justify as an investment strategy.

There are practical considerations that work against equal weighting, too, at least in theory. Daily price changes constantly cause the stocks in the index to deviate from their target weights. That can mean either large tracking errors or frequent rebalancing, leading to higher expenses and capital gains taxes.

When equal weighting makes sense

Despite its flaws, I don’t think the equal weighting strategy is nearly as problematic in ZRE as it is in more broadly based funds. First, an index fund dominated by one or two sectors, or by one or two countries, is not as vulnerable as a fund dominated by a single company. Barring Armageddon, an entire sector or country can’t go to zero. But a company sure can. Nortel once made up more than 30% of the S&P/TSX Composite and is now a penny stock—that’s the reason the iShares S&P/TSX Capped Composite (XIC) no longer allows any stock to make up more than 10% of the index. If RioCan were to implode, holders of XRE would be dramatically affected, while investors in ZRE would have much more protection.

Second, there’s a big difference between a fund with 11 stocks (like XRE) and one with 500. The academic literature suggests that a portfolio needs to contain at least 30 names or so before company-specific risk is minimized. I don’t think equal weighting makes sense for the S&P 500, where no single company represents more than 3% by cap weight. But when an index has fewer than a dozen stocks and one of them is hugely dominant, that’s a different story.

The potentially higher cost of equal weighting isn’t likely to be a problem for BMO’s REIT fund either. According to its prospectus, ZRE will be rebalanced just twice a year, and with 17 stocks, that’s not going to be expensive. Its management fee (0.55%) is also the same as its iShares competitor. By contrast, Rydex charges 0.40% for RSP, about four times more than cap-weighted S&P 500 ETFs.

So, what’s my verdict on ZRE? I’m warming up to it. While I am always suspicious of new products that claim to improve on cap-weighting (most have more to do with marketing than sound investment principles), I think equal weighting may well be a superior way to invest in a sector with a small number of companies.