Investors use the Standard & Poor's index’s performance to judge their own, and the Holy Grail is to outperform the index consistently.
But what if I told you there was a way to outperform the index consistently by buying the index itself and doing almost no work for the additional gains?
Sounds appealing and almost too good to be true.
Well, it is true, and this technique is available to every investor.
The reason this is possible is the way the S&P 500 is constructed. The index is computed by a weighted average market capitalization calculated by taking the number of shares outstanding of each company and multiplying the number by the company’s current share price. This is a relatively lazy way of calculating an index and gives more weight to larger constituents and less weight to smaller companies so the index is disproportionately affected by a decline in Apple (AAPL, Financial) compared to a smaller firm.
Outdated
This approach has worked well since the S&P 500’s inception, but it isn’t the best approach. Because small companies usually grow faster than their larger counterparts, it doesn’t make much sense to give these companies a lower weighting in the index as it stunts their impact on the broader market. Surely, if small caps are given more weight, the index would perform better overall?
That’s exactly what the S&P 500 Equal Weight Index shows. The S&P 500 Equal Weight Index does what it says on the tin. The index gives each constituent an equal weight without taking into account market capitalization or other factors. The results of using this strategy have been extremely impressive. From 2003 through 2015, a $10,000 investment in the traditional S&P 500 index would have turned into $29,370. During that same period, the same investment in the S&P 500 Equal Weight Index would have turned into $38,866. Over the past five years, the S&P 500 Equal Weight Index has returned 26.8% compared to the traditional S&P 500’s return of 23.3%.
What's behind the outperformance?
There is a belief that the reason why equal weighted indexes outperform traditional market capitalization weighted peers is due to the weighting of small caps in the index. However, according to research conducted by Robert Ferguson and David Schofield, senior investment officer and president of Intech International, there is another reason why equal weight indexes tend to outperform over the long term.
They believe the outperformance of equal weighted indexes has more to do with the index’s constituent rebalancing than anything else. For example, to maintain required equal weights, the index provider has to sell a stock after a recent run higher but also buy more of a company if it has drastically underperformed over a set period. Put simply this trading requirement creates a “buy low sell high” trading strategy, which is both contrarian and momentum chasing.
Ferguson and Schofield go on to note that surprisingly the underlying alpha source is always positive for such indicators, which is another indication that excess return has something to do with volatility. Equal-weighted indexes have a higher tracking error over time relative to the capitalization weighted index. The reason why this is the case lies in diversity.
Diversity is at its maximum if all stock capitalizations are equal. Changes in diversity influence relative return of the equal-weighted portfolio. As the capital distribution curve has a typical shape, diversity must have a typical value with no long term trend. In this case, the influence due to changes in diversity will be close to zero over time, and the outperformance of the equal-weighted portfolio will be close to its volatility-based source, which is necessarily positive (stock returns can be both positive and negative, but volatility is always positive).
When the effects of diversity are combined with contrarian/momentum investing, the equal weight index can capture higher alpha and less severe underperformance periods.
Disclosure: The author owns no stock mentioned.
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