Saturday, July 31, 2010

Equal Weighting Stocks In Ones Portfolio Might Lead To Higher Returns

In January 2003 Standard and Poor's began tracking an equal weighted S&P 500 Index versus the traditional market cap weighted S&P 500 Index. In the short seven year period, the equal weighted index (EWI) has outperformed the market cap weighted S&P 500 Index.

From HORAN Capital Advisors
To market research theorist, this seems like an odd outcome as it does not conform to the capital asset pricing model (CAPM) or Efficient Market Hypothesis (EMH). So what does CAPM and EMH imply?

According to a recent S&P report that evaluated the performance of the equal weighted and market cap weighted indices, they provide the following summary of EMH and CAPM.
The theoretical underpinnings for market capitalization weighted indices as a basis for investment lie in the Capital Asset Pricing Model (CAPM) and the Efficient Market Hypothesis.

According to the CAPM model, the expected return implicit in the price of a stock should be commensurate with the risk of that stock. However, stocks are subject to two types of risk – systematic risk, resulting from potential movements in market factors; and unsystematic risks, resulting from factors associated with individual assets. Since unsystematic risk can be diversified away, stocks should be priced solely based on systematic risk. This also implies that it is optimal to hold a well diversified portfolio in order to minimize unsystematic risk for a given level of expected return.

According to the efficient market hypothesis, it is impossible to beat the market because prices already incorporate all relevant information. Based on this, the most efficient portfolio would be the entire market and a broad market capitalization index would represent the optimal investment. However, there is much debate as to how efficient the market is in practice. Thus, there are countless different strategies being used in an attempt to beat the market. This has led to indices created based on alternative factors that measure different strategies.
In addition to the question with EMH, there are questions surrounding Modern Portfolio Theory as well. I discussed issues with MPT in an earlier post titled, Modern Portfolio Theory: Is It Over Relied On?

Recent S&P research suggests the EWI outperformance is attributable to a couple of factors. The two prominent ones are size and style. As the below graphic shows, the EWI tends to have more exposure to the mid size companies in the S&P index as well as being more tilted towards value style companies. If one reviews Ibbotson data, the best performing asset class over the long run has been midcap value. As the performance table above shows, the larger sized S&P 100 Index has underperformed the cap weighted and equal weighted S&P 500 Index.

From HORAN Capital Advisors
In conclusion, the equal weighting in the indices has provided an investor with superior returns compared to the market cap weighted indices. Investors should read the entire S&P report as it shows this higher return comes with higher volatility. Additionally, the equal weighted indices have much higher turnover (rebalanced quarterly) in order to maintain the equal weighting of the underlying holdings. This higher turnover level is likely to lead to higher capital gains being realized. And lastly, given the higher volatility in the market today and likely into the foreseeable future, an investment portfolio that has more funds allocated to larger, generally higher quality companies, should hold up better in down market environments.


Equal Weight Indexing
Standard & Poor's
July 2010

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