The oldest of these alternative indices to gain wide acceptance comes from Standard & Poor’s. The S&P 500® Equal Weight Index (EWI), launched in 2003, is an equal-weight version of the flagship S&P 500® Index. The latter is weighted according to the market cap of the companies in the index, while the former gives the same index constituents equal weight and rebalances quarterly to maintain those weights.
Ten years after the launch of S&P’s equal-weight index, it’s worth clearing up some persistent misconceptions about equal-weight indices and strategies revisiting the role that equal-weight strategies can play in a diversified portfolio.
What’s in an Equal-Weight Index?
An equal-weight index generally holds the same constituents as its cap-weighted counterpart. For example, the S&P 500 EWI holds an identical group of constituents as the S&P 500® Index—the only difference is the weighting. Rather than having a heavy concentration in a handful of the largest stocks, all stocks receive an equal weighting, which tends to lower the average overall market cap of the equal weighted version of the respective index, increasing potential diversification with increased representation from the smaller stocks.
Equal weight strategies have a smaller company bias, because they give higher weights to the smallest companies in an index constituent universe. In the S&P 500 EWI example, the bottom two size quintiles have historically outperformed over the past ten years, but are more volatile.
Finally, because they rebalance regularly, typically quarterly, equal weight strategies also sell stocks that have appreciated, trading into stocks with lower values—hence they take advantage of the “buy low-sell high” investment maxim.
Performance Characteristics and Arbitrary Bias
Bias, however, is a relative term. One could just as easily say that the cap-weighted index is “biased” toward growth and mega-cap stocks. The idea that cap-weighted indices are without bias and represent the best market proxy for all investors is itself arbitrary. What is more helpful for investors is to look at the performance characteristics of each index and then decide whether adding a product that tracks a desired index to one’s portfolio fits with the investment objective.
From its launch on 1/8/03 through 12/31/12, the S&P 500® EWI showed higher up market capture (173.86 vs 100.00) and higher annualized return (10.22% vs. 7.10%), with a higher Sharpe ratio (0.48 vs. 0.37), compared to the cap-weighted S&P 500® for the ten-year period ended 12.31.2012.
That said, equal weight strategies can also underperform. The S&P 500® EWI had a downside capture ratio of 105% during the period referenced above.And during 2008 it underperformed the cap-weighted benchmark. In addition, because they have higher weights to the smallest companies in any given universe, equal-weight strategies can be more volatile. The S&P 500® EWI showed higher volatility in the periods discussed (17.91 vs. 14.71 standard deviation).
Each Approach Has Risks and Benefits
For equal-weight strategies, rebalancing is a key factor in managing concentration risk in individual stocks, sectors and styles. Yet, during “growth markets,” or a rally in specific stocks or sectors, equal weight strategies may underperform cap-weighted strategies due to the same rebalancing approach.
Consider this example: DuPont rallied through 2010 and 2011, becoming 10% of the S&P Basic Materials Index by 2012. During the same period, the Equal Weight S&P Basic Materials Index consistently rebalanced DuPont back to approximately a 3% weight. By selling DuPont as it rallied, the equal-weighted materials index likely gave up some return.
Yet, the relative underweight to DuPont later turned out to be a huge help. In 2012, the benchmark S&P 500 returned 16%. By comparison the S&P Basic Materials Index gained only 14.93%, underperforming by 107 basis points, while the Equal Weight S&P Basic Materials Index returned 18.27%, outperforming the benchmark by 237 basis points. How did this happen?
In October 2012, DuPont released disappointing earnings and fell 15% in three weeks. The company’s 10% weight in the cap-weighted materials index created much more concentration risk than the 3% weight in the equally weighted materials index. The weighting differential to DuPont alone caused the cap-weighted sector index to under-perform the equally weighted sector index by 1.15%
Choosing What Works for Clients
As we reflect on 10 years of index innovation, and the rapid growth of alternatively weighted funds, it is important to keep in mind the goal: helping clients balance risk and reward according to their individual objectives.
In that regard, alternatively weighted funds have created many new ways for investors to balance the risk-reward equation. They offer new and compelling approaches to managing concentration risk and portfolio diversification. And they offer unique ways for investors to express their views. In short, these indices and strategies have done their job.
There should no longer be an assumed, arbitrary bias as to what constitutes the “best” broad market access—cap-weighted or otherwise. No single strategy will outperform or underperform all the time. Each has its own unique performance profile and characteristics. What’s important is that investors now have more opportunity to consider their outlook, objectives, and risk tolerances and then build a portfolio that suits them. That kind of flexibility is what we need more of.
William Belden, is the managing director of Product Development for Guggenheim Investments.