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Gwen Stefani sang an entire song about the concept of equal-weight investing and nobody realised. The Veteran explains... 👇
Equal-weight investing is the idea of investing the funds in a portfolio, equally across a basket or universe of stocks, regardless of the relative market caps and index weighting of those underlying stocks.
This idea is the exact opposite of benchmarking a cap-weighted index, such as the S&P 500, within which the largest companies exert the biggest influence.
In recent times a small group of mega-cap stocks came to dominate the S&P. This group effectively rendered the performance of hundreds of other constituents irrelevant, be it good or bad.
Simply because what happens to the stock price of Apple (AAPL) - with its $2.28 trillion market cap and 6.3% weighting in the S&P 500 - can and does move the index.
Whilst a change in the price of Alaska Air (ALK) - which has a $6.50 billion market cap and an index weighting of approximately 0.02% - will barely even register.
Cap-weighted indices are a great way to invest when the largest companies in the index are performing well. They almost become self-fulfilling trackers at that point. See the S&P 500 versus Apple chart below.
Of course when things change (as they nearly always do) the cap-weighted index tracks the downside of its largest constituents just as effectively. As our second chart of the S&P 500 versus Meta Platforms demonstrates.
The theory behind equal weight portfolios is that by investing the same amount of money into each stock in an index you can avoid this cap weighting bias.
But can you really avoid this cap weighting bias?
As far as the S&P 500 is concerned it appears you can. As long as you have patience and long enough time horizons.
The chart below compares the S&P 500 Index to RSP - the Invesco S&P 500 Equal Weight ETF (drawn in red). In the chart, we plot the respective percentage returns over 10 years.
RSP has outperformed the Cap-weighted S&P by 6.7% over that time frame but was still down on the decade. The outperformance of an equal weight allocation strategy becomes even clearer if we examine a universe of smaller companies...
Take the S&P MidCap 400 index and EWMC, the Invesco S&P MidCap 400 Equal Weight ETF.
Over the 7 years since the ETFs inception, the equal weight index has returned gains of 115.40% whilst the cap-weighted S&P Midcap 400 has delivered 'just' 92.33%.
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A recent study by Alexander Swade and others at the University of Lancaster: Why Do Equally Weighted Portfolios Beat Value-Weighted Ones? tries to shine a light on this phenomenon. The paper finds that equity factors and biases are behind the outperformance.
And in particular, they highlight the bias towards companies with smaller market caps in an equal-weighted portfolio.
Which in turn, translates into a bias towards value stocks, that tend to trade at a discount to their supposed fair value. The chart below from Swade et al shows the returns profile for various factors, in a shoot-out between the S&P 500 index and its equal-weight counterpart.
The bias towards Small-caps and value clearly stands out. However, what is surprising is that seasonality also has an important role to play, via the January effect: the tendency for stock prices to rise significantly in the first month of the year.
Academics have been inclined to dismiss these kinds of effects in the past, in the belief that they are anecdotal and transient, rather than well-documented and persistent.
And yet in this instance, the effect has been shown to be a material factor in the comparative performance of one of the world's largest equity indices.
If we think about it logically this seasonality is surely a function of human behaviour and psychology, and the feelings of “New Year, New Ideas” and fresh starts, as we look at the year ahead with newfound optimism.
It's hard to imagine that an autonomous AI-driven portfolio manager would act in the same way as human investors. As, a change in the calendar wouldn’t hold any significance to the machine beyond the actual date.
One is forced to ask as well why the fund management industry doesn't bang the gong for equal-weight portfolios. After all, many pension funds are underfunded and underperforming. Over these long investment performance horizons an equal-weight strategy might make all the difference.
Could it be that explaining the benefits is too much like hard work, and if it were successful it might detract from the nice little earner that passive cap-weighted ETFs and mutual funds have become?
The market cap of SPY the world's largest ETF is $380 billion and even at an annual expense ratio of 0.09% the fees soon mount up to $342 million per annum.
Perhaps Munger was right...
“Show me the incentive and I will show you the outcome”