Equal Weighting Works, but Why?
Klaus A. Wobbe
CEO at Intalcon Group of Companies | Asset Management - Systematic Investment Strategies – Foundation
Alexander Swade and his colleagues from Lancaster University [1] try to find the biggest drivers of differences in returns between equal-weighted and market cap-weighted S&P 500 index. Is it because of the small cap bias or other factors? And how did the market behavior change before and after the world financial crisis? This is the topic of the latest article from our guest author, Joachim Klement [2]. With just one click, his article is also available in German language.
I have been an advocate of equal weighted portfolios essentially since the original study by de Miguel and others was published as a working paper in 2006. I have argued for more than 15 years, once you take uncertainty about future returns of assets into account, an equal-weighted portfolio is almost impossible to beat in the long run.
The reason why equal-weighted portfolios work, in my view has to do with our inability to forecast future returns with any reasonable degree of certainty. But of course, other people would argue that equal-weighted portfolios outperform because they give you systematic exposure to risk factors that outperform in the long run. Clearly, if you put the same amount of money into all the stocks in your portfolio you are introducing a significant small cap bias compared to a market cap-weighted index like the S&P 500. You are also introducing a bias in favour of value stocks since value stocks typically are value stocks because their market cap has dropped significantly in the past relative to their earnings. But which factor dominates and are there any other factor exposures that play a role?
This is the question that Alexander Swade and his colleagues from Lancaster University tried to answer. The chart below shows that the biggest contribution to the difference in returns between equal-weighted and market cap-weighted S&P 500 comes from the small cap bias. This bias is about three times as important as the value bias inherent in the equal-weighted index.
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But there are other important effects. Equal-weighted portfolios benefit less from momentum effects than market cap-weighted indices thus creating an underperformance if the market is driven predominantly by momentum.
On the other hand, equal-weighted portfolios benefit from their higher allocation to highly profitable companies. And then there are a host of other factors that benefit the equal-weighted portfolio. But as the chart above shows, outside of the size and value effects the other contributions can vary a lot. As the chart shows the contributions to equal-weighted outperformance before and after the GFC. The key difference between these periods is that after the GFC, we had zero interest rates and low growth. And as I have written before, that has significantly changed stock market behaviour. Going forward, we may be heading back into an era of higher interest rates or, as I believe, the current episode of higher rates is just temporary and we are heading back to a low growth, low rates environment. Either way, the factor exposures of equal-weighted will change, but two factors will remain the key driver of outperformance: three parts small cap and one part value.
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[1] Swade, Alexander and Nolte (Lechner), Sandra and Shackleton, Mark B. and Lohre, Harald, Why Do Equally Weighted Portfolios Beat Value-Weighted Ones? (November 18, 2022). Journal of Portfolio Management, Forthcoming, Available at SSRN: https://ssrn.com/abstract=4280394
[2] https://klementoninvesting.substack.com/
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2 年The argument for equal-weighted portfolios as a long-term investment strategy is compelling, as it takes into account our inability to predict future returns with certainty. The small cap bias inherent in an equal-weighted portfolio is the main factor contributing to its outperformance over market cap-weighted indices, while value bias plays a smaller role. Other factors, such as momentum effects and allocation to highly profitable companies, also impact performance, but their contributions can vary significantly. The upcoming changes in interest rates and market conditions may affect the factor exposures of equal-weighted portfolios, but the small cap and value biases are likely to remain key drivers of outperformance.
Financial Journalist
2 年If only there was no arithmetic to that. The main drawback is that equal-weight strategies are size constrained and thus, not everybody can invest like that. There are higher transaction costs (also for rebalancing) which rise further the more people implement it until the benefits erode at some point. Also for the easy solution of equal-weight ETFs expense ratios are higher than for cap-weighted.
Alpha Engines for #HNWI, #familyoffice, #hedgefund and RIA portfolios . Focus on macro and digital spaces. Stoic Epicurean (!) Atomist believing in duty. Fine art photographer.
2 年Alpha for impact? I'd guess 90% beta, betting on small caps as a specific factor (kind of stating the obvious since market cap weighted indices are biased towards ... large caps !!!). I'm not against beta as a legitimate form investing (I like it a lot actually, only when it is managed), but I would not go as far as calling it alpha.
Deputy Head of the Quantitative Research Group
2 年Nice! That should exhaust the discussion about EW ?? ... or does it? Well, I am not sure you neutralized sectors, or at least it does not appear so. If not, then with sector neutral factors you could check the additional contribution from sectors. And that may be a bit random depending on the country or region you look at...
Head of Quant Equity Research at Robeco
2 年Thanks for flagging our work, Klaus A. Wobbe. Likewise thanking Joachim Klement for your excellent summary. Spot on! Working paper version is still available here: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4280394