Equal weighted vs. Market cap weighted

By Larissa Fernand |  09-12-21 | 
 
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About the Author
Larissa Fernand is an Investment Specialist. Follow her on Twitter @larissafernand

Strategic beta, which many often refer to as “smart beta,” is a hybrid of active and passive approaches to portfolio construction. It tries to marry the best of both worlds - active bets with the best of passive approaches. The active parent of this hybrid creation introduces a variation against just owning the market outright.

The simplest of these strategic beta approaches over traditional indexing is equal weighting. It effectively takes the universe of stocks in an index and weights them equally across all the securities.

Diversification.

In a market-cap-weighted strategy, you end up owning more of the larger stocks because they have a greater weight in the index. In an equal weight strategy, you diversify it across a broader range of securities and sectors within the index.

In certain market conditions or market environments, the concentration of stocks into one sector that is performing really well benefits a market-cap-weighted strategy. It benefits when the market is going up, but then you also are impacted negatively on the downside. In an equal weight strategy, where you have a much smaller weight to a single stock exposure, your performance (positive or negative) isn’t as impacted by that single stock as you would have been in the market-cap-weighted strategy.

Risk.

You get in the broader index but with less risk from a security concentration or sector concentration standpoint. In essence, you are reducing your overall security exposure risk. On the flipside, you do pick up a little bit more volatility because you are tilting to those smaller names (depending on the index).

Re-balancing.

An equal weight strategy is rebalanced periodically; often on a quarterly basis. What effectively happens when that rebalance takes place is you are harvesting your winners and you are reinvesting in your losers. So, it's a constant sort of contrarian disciplined rebalancing that adds value over time. On the flipside, a market-cap-weighted strategy would just let that weight continue to ride as long as the stock is going up. Should leadership of that stock, and its performance turn, it would go down and the market would go down subsequently with that stock.

Value tilt.

Rebalancing an equal-weight index also injects a mild value tilt into the portfolio. In order to maintain its desired weights, the strategy will sell shares that have appreciated relative to their target weight and use the proceeds to buy those that have declined since the previous rebalance.

By assigning the same weight to each constituent, the equal weight index is simply tilting toward stocks with smaller market capitalizations and lower valuations, which have historically outperformed their larger and more expensive counterparts. Mechanically shifting assets away from companies that have become more expensive and toward those that are now cheaper can be an advantage when the market’s valuation reaches extremes (either too expensive or too cheap).

Factor exposures.

When we think of strategic beta strategies, a lot of the economic thesis behind these strategies is rooted in factor investing. An equal weight strategy causes you to tilt away from the largest-cap names. You also end up tilting a little bit more value. Because the leadership of the market-cap-weighted index is driven by the larger stocks, there is more momentum in a market-cap weighted strategy, and in an equal weight strategy you end up taking on more value exposure than the market.

A market-cap-weighted index product essentially 'doubles down' on its best-performing constituents. It can be a great ride when those stocks are firing on all cylinders. Take FAANG, for instance. It is an acronym denoting the most popular American technology companies: Facebook, Amazon, Apple, Netflix, and Alphabet’s Google. These companies make up a significant portion of the S&P 500 and thus have an influential effect on the index's movement and returns for investors. But should they hit a rough patch, as they did end-2018, the repercussions will be felt.

Or, take the Nifty, which is comprised of 50 stocks. The largest stock has a weight of 10.7%; the top three have a 27.9% weight in the index, and the top 10 have a weight of 58.3%. This skews diversification as well as performance.

Remember this...

An equal-weight benchmark offers investors the dual benefit of reduced concentration risk and increased exposure to smaller stocks.

There are a few drawbacks. You do end up having slightly higher turnover in the portfolio. It's not significant, but more than the traditional market-cap-weighted strategy. And the fund with the equal weight-strategy will underperform the index when certain stocks are galloping ahead. Though over the long run, it should even out.

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