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The Skew and Equal-Weighting

by: Lawrence Hamtil     

Indexing advocates like to point to the historical skewness of stock returns as evidence that indexing by market valuation is the surest way to capture what rewards the stock market offers.  The logic of this popular argument seems sound:  history shows that only a handful of stocks are responsible for the market's aggregated gains over its history, and attempts by active management to beat the market are usually done so with concentrated portfolios, which inevitably underperform because active managers fail to identify, let alone capture, those few stocks that generate outsized gains.

However, as we have explained before, this logic is faulty, as portfolios based on market capitalization simply overweight yesterday's winners, and reduce exposure to the smaller components that may offer more promising rewards going forward.  S&P's research team explored this dynamic in their excellent paper, "Outperformance in Equal-Weight Indices."  The authors demonstrate that by virtue of its periodic rebalancing, - which results in an equal spreading of bets across the index's components, - the equal-weighted version of the S&P 500 has offered investors more exposure to extreme winners over time than the capitalization-weighted index (via S&P Dow Jones):

To emphasize this concept, here are a few interesting statistics regarding the composition and component performance history of the S&P over the last few decades:

  • From 1980 to 2017, only 47 different companies were represented in the top ten weightings in any given year.
  • Over the same period, 289 different companies were among the top ten annual performers.
  • In only two years since the S&P 500 went to a capitalization-weighting composition in 1988, - 1995 (Microsoft) and 2008 (Wal-Mart), - was a top ten weighted stock at the end of the previous year a top ten performer in the following year.
This last bit is important, as the weighting of the top ten components of the S&P 500 has averaged roughly 20% since 1980:

In essence, even though capitalization-weighted indexing in the U.S. has exhibited more dynamism than in many other markets around the world, the reality is that this form of indexing is consistently placing bets on a largely unchanged group of stocks.  Equal-weighting avoids this concentrated bet making, which, combined with an inherent tilt to size and value, make it an effective and superior strategy in most instances.

The information provided above is obtained from publicly available sources and it is believed to be reliable. However, no representation or warranty is made as to its accuracy or completeness.

Lawrence Hamtil is a fourteen-year veteran of the financial services industry, having served clients in all aspects of the business during his career, which started in 2002. In 2005, he joined Dennis Wallace of Fortune Financial Services, LLC, becoming, at the time, one of Multi-Financial Securities, Inc's youngest registered representatives. In 2008, Dennis and Lawrence made the decision to become fully independent by founding their own Registered Investment Advisory (RIA), Fortune Financial Advisors, LLC. He serves clients in the United States and Europe. His financial commentary has been referenced in Barron’s online edition.

You can connect with Lawrence on Twitter ( @lhamtil) or via email, lawrence.hamtil@fortuneadv.com.