Weighting stocks based on market capitalization has long been the design standard for most index funds, but a recently launched ETF turns the strategy on its head. The Reverse Cap Weighted US Large Cap ETF (RVRS) holds the familiar S&P 500 names but in weights that are inversely proportional to their market cap. For example, the largest stock has the smallest weight and the smallest has the biggest footprint. What’s the rationale behind the strategy? Isn’t this just another twist on tapping into the small-cap factor? The Capital Spectator recently asked Herb Blank, a senior consultant at Global Finesse, to explain the motivation behind the strategy. In a recent study (“The Case for Reverse-Cap-Weighted Indexing”), Blank and co-author Qiao Duan report that reverse weighting outperformed the conventional S&P 500 for the ten-year period through 2016. The results offer “an intriguing alternative weighting scheme with the potential to realize superior rates of return,” they write.
Define reverse market-cap indexing.
It’s simply calculating the reciprocal of the float-weighted market capitalization (1/market cap) of every company in the index, then summing those reciprocals. Next, every stock’s weight is derived by taking that same reciprocal and dividing it by the sum of those reciprocals.
What’s the investment rationale for an equity index strategy that tracks reverse market-cap weights?
As detailed in the paper I co-authored, S&P 500 index funds beat more than 80%-plus of actively managed core equity funds on an after-tax and after-fee basis. It’s tough to beat. That said, it does have well-documented biases favoring mega-cap stocks with recent price run-ups. Since smaller-than-mega-cap stocks, value, and mean reversion are three well-documented anomalies, the S&P 500, while formidable, cannot be the best possible weighting scheme for those 500 large cap stocks.
In fact, the equal-weighted S&P ETF, Guggenheim S&P 500 Equal Weight ETF (RSP), has outperformed SPDR S&P 500 ETF (SPY) by more than 300 basis points per year since its inception.
In the paper, we divided the S&P 500’s names into the top 120 stocks by market cap and the next 380 stocks in order to calculate expected returns for the S&P 500 vs. the equal-weighted S&P 500 and the reverse-cap-weighted S&P 500. We worked with the hypothesis, given the anomalies, that the average expected return in a given quarter of the top 120 market-cap stocks would be less than the expected return of the remaining 380. We then demonstrated that when that was true that in the preponderance of cases reverse market-cap weighting would outperform equal-weighted, which would outperform cap-weighting. In summary, when equal weighting beats market-cap weighting, then reverse market-cap weighting will beat both equal weighting and market-cap weighting most of the time.
Isn’t reverse-market cap weighting just another flavor of the small-cap factor?
Actually, no. The index is comprised of the same 500 large-cap stocks that are in the S&P 500. But the lowest cap stock in the S&P 500, which is the largest holding of the reverse market-cap weighted index, had a $3.9 billion market cap in September 2017. At the same time, the largest cap holding of the small-cap FTSE Russell 2000 Index was $2.8 billion. Using a truer small cap index, such as the equal-weighted Small Cap US Index provided by Dimensional Fund Advisors, makes the Reverse Cap-Weighted S&P 500 Index even less like a small-cap index. Personally, I’ve always questioned to what extent an investor was capturing desired exposures to the small cap part of the US market when using a cap-weighted small-cap benchmark.
Your research shows a substantial premium in the historical record for reverse market-cap weighting over the standard S&P 500 and its equal-weighted counterpart. What’s driving the alpha? Is this a risk-based story or is the expected premium for your benchmark linked to behavioral factors?
The rationale comes from a host of empirical studies of market anomalies linked to cap weighting. In particular, the mega-cap, anti-value, and anti-mean-reversion biases inherent in a cap-weighted index of large-cap stocks all contribute to the index’s performance behavior. That said, since the reverse cap-weighted index has the highest beta and standard deviations of returns, the superior returns do come, at least in part, from taking on more weighted market risk than the S&P 500 Index.
A new ETF that tracks your index was recently launched: Reverse Cap Weighted US Large Cap (RVRS). How is the fund managed with respect to the index? In particular, how often is it rebalanced, what’s the expected portfolio turnover, and where does the ETF fit in with respect to a diversified US equity asset allocation?
I can only speak with authority about the index study, not the fund. The index is constructed and maintained by S&P Custom Index Services. It is rebalanced and reconstituted quarterly. It is my understanding that the fund will also be rebalanced and reconstituted quarterly since the objective of the fund is to replicate substantially the price and total return performance of the index. The historical simulated turnover for the index was 43.4% percent annually. That would also be my best estimation of expected future turnover. Since I consider the index to be an alternative core weighting scheme, it’e best thought of as a replacement for a long-term core index holding or as a tool to be used by tactical investors and hedge funds expecting strong overall equity performance in the coming period.