Who doesn’t love a good story?

That’s what thematic ETFs offer investors by building a portfolio of stocks around a very specific investment idea. The latest member of this group is the Alps Workplace Equality Portfolio Fund (EQLT ). The ETF, which tracks U.S. companies that provide equal benefits for lesbian, gay, bisexual and transgender employees, is a progressive new spin on the socially conscious investment theme.

When you dig into how EQLT works, a different story line emerges. Like many of its thematic peers, EQLT tracks an index that weights stocks equally. In the S&P 500 Index, by contrast, stocks with the largest market capitalizations get the largest weightings. By going the equal route, products like EQLT give smaller stocks a louder voice in performance. That can increase returns in a broad market rally, when small-caps tend to outperform, but also brings added risk and can create the illusion that a theme is working when it’s actually the small-cap bent that's providing the edge.

Right now, an equal-weighting strategy is paying off for many theme ETFs. Small-cap stocks have outperformed large-caps by a wide margin over the past five years. The Russell 2000 Index, the benchmark for small-cap stocks, had a 225 percent return, compared with the S&P 500's 175 percent.

But small-caps also tend to fall farther in downturns. The Russell 2000 lost 21 percent in 2011 as concerns grew that Europe's debt crisis would spread and the credit rating of the U.S. was downgraded. The S&P 500 fell 13 percent over the same period.

Equal Voice

Equal-weighting thematic portfolios is actually a pretty brilliant idea from an issuer’s standpoint, because beating the S&P 500 will make it easier to attract assets. That's not to say it's done to pull one over on investors. Depending on the narrowness of the theme, equal weighting can be one way to diversify and avoid having a few big companies utterly dominate an ETF.

In EQLT’s case, “we acknowledge that there is a small-cap bias, but that decision was made to give all of the companies an equal voice,” says the ETF’s portfolio manager, John Roberts of Denver Investments. “After all, it is an ‘equality’ ETF.” Roberts says the S&P Equal Weight Index is a better benchmark for the ETF than the S&P 500. The fund, which launched February 26, has just over $5 million in assets.

To look at the performance of the index that EQLT tracks, you’d think companies offering equal workplace benefits are way better performers than other, stingier companies. Over the past year, the index is up 32 percent, compared with 21 percent for the S&P 500. When you look at the portfolio and analyze where those returns are coming from, you find that EQLT has 10 percent in small- and mid-cap stocks, and also owns some smaller large-cap stocks. And it’s that chunk of the portfolio that's contributing the lion’s share of the excess return -- and risk.

To see how that can play out in a portfolio, look at Electronic Arts Inc. (EA ). It’s a large-cap company, but on the smaller side, so the S&P 500 Index gives it a .05 percent weight. In the equal-weighted universe of EQLT, it gets a .74 percent weighting. Doesn’t seem like much of a difference, but that means EA’s one-year return of 58 percent has 15 times as much impact in EQLT as in the S&P 500. It also means that EA’s risk has 15 times as much impact in EQLT.

Electronic Arts' stock is three times as volatile as the S&P 500, and there are other examples like it in EQLT’s portfolio. The weightings explain why the beta of the ETF’s index is slightly above that of the S&P 500. Beta measures a stock’s volatility; a beta of 1 means a stock basically moves in line with the broad market. A stock with a beta above 1 will most likely outperform the S&P 500 in good times and most likely underperform the index in bad times.

GURU Followers

Perhaps the highest profile example of a thematic ETF achieving huge success from an equal-weighting strategy is the Global X Guru Index ETF (GURU ). It tracks changes in stocks held by large hedge funds, zeroing in on what stocks it determines are managers’ high-conviction picks. Since GURU was launched in June 2012, it has returned 74.9 percent, compared with the S&P 500’s 49.7 percent. That has earned it tons of publicity and over $500 million in assets.

GURU offers value to investors by poring over hundreds of hedge fund filings every quarter. But when you break down where its excess return comes from, a big chunk is due to its 20 percent weighting in small- and mid-caps. A lesser chunk comes from smaller large-cap companies with either little or no weight in the S&P 500. This is a big reason GURU has beaten the market. It’s also why during the January selloff it lost 4.9 percent while the S&P fell 3.4 percent. Two GURU spawn -- the Global X Guru Small Cap Index ETF (GURX ) and Global X Guru International Index ETF (GURI ) -- use equal weighting as well. Both those ETFs and EQLT have the same expense ratio as GURU, which is .75 percent of assets on an annual basis.

The Robo-Stox Global Robotics & Automation Index ETF (ROBO ) also goes the equal-weighted route. Since its launch last October, it has returned 6.4 percent to the S&P 500’s 5.9 percent. It has attracted over $100 million in assets -- a huge feat for a niche ETF. ROBO has over 60 percent of its portfolio in small- and mid-cap companies. Its expense ratio of .95 percent is significantly above the average for equity ETFs.

An exception to the equal-weighting trend among theme funds is the Nashville Area ETF (NASH ). It owns stocks headquartered in ... yep. NASH uses a multi-factor weighting using fundamentals and technical metrics for its basket of stocks; weights are spread around with the top stock weighted at 7.2 percent and the bottom stock at .82 percent. Since its launch in August 2013, NASH has returned 7.5 percent; the S&P 10.7 percent. Despite a lot of publicity, NASH has brought in only $6 million in assets. It also differs from its equal-weighted peers in not falling much farther than the broad market in January’s sell-off.

For investors interested in the themes behind these ETFs, there’s no reason to swear them off. Just be aware that an ETF’s theme may not be the primary driver of its performance.

Eric Balchunas is an exchange-traded-fund analyst at Bloomberg. More ETF data is available here , and weekly ETF podcasts can be found here .

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