A recent academic paper, Equal or Value Weighting? Implications for Asset-Pricing Tests, highlights two methods of weighting: Equal-weight and Value weight.
As the paper states:
With monthly rebalancing, an equal-weighted portfolio outperforms a value-weighted portfolio in terms of total mean return, four-factor alpha, and Sharpe ratio…The higher systematic return of the equal-weighted portfolio relative to the value- and price-weighted portfolios arises from its relatively higher exposure to the value, size, and market factors.
This paper summarizes the key findings from an old post we did almost a year and half ago:
The Value-weight VS. Equal-weight Update
We updated the EW vs. VW horse race with latest data: From 1/1/1963 to 2/28/2015, SP500 Equal-weight outperforms SP500 Value-weight by 2.25%, annually. The strategy delivers higher Sharpe and Sortino ratios.
Many people attribute the EW premium to the “size” factor. What does that mean? As we know, the SP500 EW includes the exact same companies as the SP500 VW, however, the EW version gives equal-weight to each company, regardless of size. In other words, Apple Inc (Market Cap: ~755B) has the same weight as Diamond Offshore Drilling Inc (Market Cap: ~ 4.46B) in the EW index.
So size is definitely one reason why the EW index has likely outperformed the VW index, but size isn’t everything…
Factor analysis on SP 500 EW
Below we highlight the factor analysis for the S&P500 EW. A few observations:
- A small size tilt (as measured by SMB).
- A fairly large exposure to the “value factor” (HML), which suggests that the EW Index performance is driven not only by size, but also by value!
- The EW index also a beta of ~1.1, giving it a little more market risk than the VW index.
Below we show the factor analysis of S&P500 VW. A few comments:
- A beta of 1, which is intuitive.
- A negative size factor (i.e., the value-weight index tilts large).
- A flat value exposure.
Casual market observers suggest that the EW index is driven by a small cap bias. This observation may a bit too casual.
The evidence suggests that much of the outperformance is likely driven by a heavy value exposure and a slightly higher beta.
Going forward, and assuming that the factor loadings stay the same, we can expect the S&P 500 EW index to outperform if small-caps earn a premium, value-stocks earn a premium, and the market continues to grind higher over the long-haul.