Learning Curve: The merits of equally weighted portfolios
While market capitalisation weighted indices and portfolios have been incredibly popular in recent years, data show that their equally weighted brethren can have an edge with lower concentration risk and better performance.
By Timo Pfeiffer, head of research and business development at Solactive, and Emanuel Cozmanciuc, quantitative research analyst at Solactive.
There are several weighting schemes to choose from when constructing a portfolio or an index. One of the most common is the traditional market capitalisation (MCAP) method, also known as value-weighting, in which securities are weighted proportionally to their market value.
Another well-known method — which has gained more traction in recent years — is equal weighting (EQW), in which all securities are given equal proportions, regardless of their market capitalisation. Different weighting schemes will result in different properties for otherwise identical portfolios.
In our research paper, When Size Doesn’t Matter – Equal Weighting vs Market Cap Weighting, we analyse the characteristics of equal weighting and contrast them to those of MCAP weighting. We first examine the historical performances of EQW portfolios and MCAP weighted ones, while comparing two indices that have the same compositions but different weighting schemes.
The analysis covers both the US and the European markets, using the Solactive US Large Cap Index as the starting universe for the former, and the Solactive Europe Total Market 675 Index for the latter.
Over the period of evaluation, between February 2000 and October 2017, the results confirm that EQW outperforms MCAP in both markets, with EQW also resulting in larger drawdowns in both markets. It is interesting to see that in the US EQW leads to higher volatility, as expected, but not in Europe, where volatility is surprisingly lower.
Characteristics of equal weighting
Weighting equally in contrast to weighting proportionally results in different risk and return values atv the portfolio level. Similarly, risk factor exposures, such as sector and country, will be different. While these different exposures lead to different performance characteristics, they are specific to each case.
From a more general perspective, the following features could be expected of all equally weighted portfolios:
Lower concentration risk
Diversification does not refer solely to a large number of portfolio members from different sectors. The weights of the stocks play a key role. Even when MCAP and EQW portfolios share the same (large) number of stocks, MCAP weighting leads to a high concentration in the largest companies.
Looking at the Solactive US Large Cap Index, which is composed of 500 stocks, the largest 15 companies in the MCAP weighted version account for 25% of the entire portfolio. Conversely, 25% of the EQW version is represented by 125 stocks.
We simulated the historical performance of the 15 largest stocks in the composition — 25% of the MCAP weighted portfolio — and the performance of the 125 largest stocks — 25% of the EQW portfolio. Unsurprisingly, the more diversified portfolio exhibited not only better performance, but also lower volatility and smaller drawdowns despite its smaller capitalisation tilt.
Higher exposure to small capitalisation stocks
By construction, an EQW portfolio exhibits substantially higher exposure to smaller cap stocks than an MCAP portfolio. Historically, small caps generally show better performance than large caps. We confirm this claim by backtesting the 50 smallest stocks and the 50 largest stocks in the compositions. This characteristic is also intuitive: smaller companies have more room to grow.
This fact leads to the assumption that the higher exposure to small caps probably accounts for a substantial part of the outperformance of equally weighted portfolios — a hypothesis that is tested and verified in the paper when we break down the outperformance of EQW over MCAP portfolios. More than half of the outperformance is explained by the smaller-cap stocks.
Inherent ‘buy low, sell high’ feature — a ‘rebalancing effect’
Assuming no component changes (ie no stocks in or out of the portfolio) and no corporate actions, a purely MCAP weighted portfolio would not require weight adjustments from rebalancing to rebalancing, as the weights dictated by MCAP are already reflected in the share prices.
Under the same assumption, maintaining equal weights among portfolio components still requires adjustments like selling some shares of the stocks that appreciated in value and buying more shares of the stocks whose prices fell.
Thus, any gains are locked in and are used to increase exposure to the now cheaper underperformers. This characteristic of an EQW portfolio is essentially a “buy low, sell high” trading strategy. It means that if a reversal in stock prices occurs, an EQW portfolio is perfectly positioned to take advantage of this process.
To illustrate this effect, we have constructed and back-tested four portfolios with identical compositions but different rebalancing frequencies. One portfolio starts with equal weights and is never rebalanced. The other three are brought back to equal weights quarterly, weekly and daily, respectively. The results reveal that returns increase with the frequency of rebalancing.
Higher portfolio turnover
However, the dynamics of the EQW portfolio described above also lead to higher turnover. Yet, this is not a problem, as the extra transaction costs are more than offset by the excess returns. This conclusion holds even if we assume very conservative transaction costs of 50bp for our quarterly rebalanced portfolios (the transaction costs for non-retail traders can be less than 10bp).
Finally, we break down the outperformance of EQW over MCAP in line with the characteristics described above.
In both the US and Europe, most of the outperformance of EQW over MCAP weighting is explained by the higher exposure to small cap stocks, whereas the rebalancing effect (bringing stocks back to equal weight) only has a minor effect.