- Equal-weight indices are easy to understand, amply diversified, and superior to cap-weight indices in long-term performance
- Equal-weight indices have higher turnover and less liquid stocks than fundamentally weighted indices; they are also prone to select stocks that are more likely to be overpriced.
- The net-of-cost performance of an equal-weight strategy falls off with asset size much faster than a fundamentally weighted strategy.
Equal-weight indices have two clear advantages: They are easy to understand, and they generally outperform cap-weight indices over the long term. Their drawbacks are less apparent. They have higher turnover due to rebalancing than other smart beta strategies, and that turnover includes buying and selling lower-liquidity stocks. Our market impact model demonstrates that, as global assets under management increase, implementation costs tend to rise faster in equal-weight than in fundamentally weighted strategies. This article summarizes what we have learned about the relative performance of equal-weight indices before and after implementation costs.
The very first index fund, created by Wells Fargo in 1970, equal-weighted the stocks in the NYSE index. But it didn’t last very long. The process of trading stocks to maintain equal weights was too time consuming and costly.1
That historical outcome might surprise modern investors. Consider, however, that until 1975 the brokerage commissions were set by NYSE (even for institutional trading), and they were 10–15 times higher than they are today (Eisenach and Miller, 1981). In addition, computers were just emerging on Wall Street, and the effort involved in making them work often exceeded any benefits they offered. Because equal weighting was impractical in those times, capitalization weighting—a buy-and-hold strategy for index investing—became the predominant industry standard.
By the 1990s, however, major index providers started offering equal-weight versions of certain indices. In the past decade, the range of equal-weight indices increased, and ETFs and other investable vehicles linked to these indices came to market. More than 40 years after the first attempt, equal weighting finally took off as a viable approach to index investing.
It might seem that an investment strategy as incredibly simple as equal weighting couldn’t possibly offer anything of interest to sophisticated investors. But equal weighting should not be dismissed so quickly. Without a material increase in risk, the equal-weight strategy robustly outperforms the traditional cap-weight benchmark on a gross basis.
If equal-weighted strategies are not only easy to understand but also provide better risk-adjusted returns than cap-weighted indices, why should anyone bother with a more complicated smart beta strategy such as the fundamentally weighted approach? For two reasons: The fundamentally weighted approach outperforms its equally weighted counterpart before accounting for costs; and it also has lower implementation costs. In addition to reviewing simulated performance records, we will describe the mechanism that drives the returns of both smart beta strategies, and we will explain why selecting and weighting stocks on the basis of fundamentals uses the mechanism more efficiently.
Both fundamental and equal-weight strategies owe their attractive performance to the noise in prices—the fact that stocks are often mispriced—and the tendency for stock prices to reverse direction and head back toward their long-term averages. Stocks that are temporarily overpriced automatically receive a higher weight in the cap-weighted benchmark; conversely, stocks that are temporarily underpriced are given a lower weight. This internal dynamic causes a performance drag for the cap-weight strategy: it overweights expensive stocks, magnifying the adverse return impact when their prices revert toward the mean, and it underweights cheap stocks that may be poised to rise in price.
In comparison, fundamentally and equally weighted strategies avoid the return drag because they do not use prices as weighting inputs.
Nonetheless, there are important differences between the two strategies. First, the equal-weight strategy disregards not only stock prices but also the size of the companies in the index. Consequently, it takes disproportionate positions in smaller—and therefore less liquid—stocks. These bets only indirectly capture the noise in prices, and are therefore less effective in generating performance. In addition, as one might expect, they create very significant implementation costs. The fundamental-weighted strategy breaks the link between stock price and index weight while still maintaining a high degree of investability. It achieves this by maintaining a systematic relationship between a company’s index weight and its economic size, as reflected by the financial variables that serve as weighting factors.
Second, equal-weight strategies select the stocks they hold by market capitalization (when, for example, their construction rule is to equal-weight the largest 100 stocks in a given universe). Well-designed fundamental indices select as well as weight stocks on the basis of fundamental metrics. This key methodological difference contributes to the performance advantage enjoyed by the fundamentally weighted strategy: the stocks that are selected by the equally weighted index, and not by the fundamentally weighted strategy, are more likely to be overpriced. The selection effect would disappear if the equal-weight strategy were to invest in the entire universe of stocks; however, this would further impair investability, because microcap stocks would get the same allocation as the largest of the large-cap stocks in the opportunity set.
In a long-run simulation, the fundamentally weighted strategy outperformed equal weighting by as much as 280 bps.
Table 1 shows the hypothetical performance of the two smart beta strategies and the cap-weight benchmark in multiple countries from 1985 to 2013. Here, the starting universe is set to the 85th percentile by cumulative market capitalization (for the cap-weight and equal-weight strategies) or by cumulative fundamental weight (for the fundamental strategy). This threshold leaves a modest amount of room for the selection effect to play a role. Over the measurement period, the annualized returns of both smart beta strategies exceed those of the cap-weighted benchmark in almost every case, and the fundamentally weighted index consistently outperformed the equally weighted one.