Most of the major market indices that we follow are capitalization weighted. This means that each stock's percentage weight in the index is based on the value of the company's shares as a percentage of the value of all firms within the index. 

For example, if a Company A has 10 shares outstanding and each share is worth $10, then it has a market capitalization of $100. If Company B has one share and it is worth $25, then its market cap is $25. In this example, Company A would then account for 80% of the index.

This kind of weighting means that as share prices increase, the larger stocks tend to get bigger and the smaller stocks tend to account for a lesser percentage of the underlying index. The Rydex Equal-Weight ETF avoids this problem. It holds all 500 stocks in the S&P 500 Index (^SPX) in equal weightings (these weightings are based on the start date of the fund, so there are minor differences). In other words, General Electric (GE) approximately comprises the same 0.2% of the fund as does the smallest company in the S&P 500, Piper Jaffray (PJC). By comparison, it's worth noting that GE makes up about 3.2% of the traditional market-cap weighted S&P 500 Index, yet PJC accounts for less than 0.01% of it.

Studies have shown that this type of equal-weighted index has outperformed the capitalization weighted index going back to 1989. The equal-weighted index outperformed by a cumulative +30% between late 1991 and the middle of 1999, but underperformed by -50% from mid-1999 until early 2001. Essentially, when large-cap stocks are doing very well, the cap-weighted index will perform better. However, when small and mid-cap stocks are out performing, the equal-weight index will do better.

The one key advantage to an equal-weight index is that you pretty much always know what the fund holds. When individual stocks and sectors start to outperform, they begin to account for a larger and larger percentage of a weighted index. This significantly raises the risk in your portfolio, as the fund becomes less diversified. This means that during powerful bull markets, equal-weight indices will tend to substantially underperform their cap weight counterparts (meanwhile, in a sharp bear market, the opposite is true). This was borne out by the performance in the S&P 500 equal-weight and capitalization weight indices since 1998.

The correlation, using monthly returns, between the S&P 500 equal-weight and cap weight indices is about 92% going back to January 1990. This is lower than the correlation between the Dow Jones Industrial Average and the S&P 500. In fact, this 92% correlation is very similar to the correlation between the S&P 500 and the S&P 400 Mid-Cap Index (that exact correlation is 89%). Essentially then, the equal weighting gives the S&P 500 a similar look to a mid-cap weighted index even though there is no overlap in the actual stock holdings.

The question then comes as to why you might want to hold the Rydex S&P 500 Equal-Weight Fund (RSP) as opposed to something like the Mid-Cap SPDR (MDY). The correlations between the two are similar. MDY trades with higher volume and therefore shows a tighter bid/ask spread. Note, however, that RSP's volume, which had been stuck near 20,000 to 30,000 shares per day, has recently picked up, often reaching over 70,000 shares. In fact, on November 3rd more than 320,000 shares of this fund changed hands.

The higher volume on MDY is an advantage for that fund, as is the typically tighter bid/ask spread. Favoring RSP is the fact that you have probably heard of most of the stocks in RSP. You can more easily hedge RSP issues than MDY issues and there are more options trading possibilities based on the holdings in RSP as well. There is also certainly more analyst coverage of the issues held in the S&P 500 as compared to those in the S&P 400.

Another use of RSP would be to hedge one fund with the other. Because they act similarly, you can hedge a long MDY trade with a short RSP position, and vice-versa. This fund might also allow you to take a tax loss on MDY, as you could purchase RSP in the meantime to avoid the wash sale rule.

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