Research Review | 5.11.2011 | Equal Weighted Portfolios

Update on MSCI Equal Weighted Indices
MSCI Research Bulletin | Dec. 2010
This paper illustrates the effect of equal weighting an index relative to a capitalization weighted index. An equal weighted index exhibits a small cap and value tilt, lower index concentration, and more stable sector weights. However, an equal weighted index has higher index turnover and lower investment capacity relative to a capitalization weighted index. Over the last twelve years (December 1998 to October 2010) the MSCI Equal Weighted Indices outperformed their capitalization weighted counterparts in the major countries and regions analyzed. This outperformance appears to be mainly driven by the small cap and value tilt, which are well-documented sources of excess return in financial literature.

Why Do Equally Weighted Portfolios Outperform Value Weighted Portfolios?
Yun Taek Pae (Lewis University) and Navid Sabbaghi (Illinois Institute of Tech.) | Sep 3, 2010
This paper suggests a number of implications for both academia and industry. First, equally weighted portfolios outperform value weighted portfolios in the effcient market. Our theoretical results are based on the Modigliani-Miller theorem and the Capital Asset Pricing Model. Since these two theories assume the effcient market, market ineffciency is not the only explanation for the positive return difference as suggested by the literature. Second, the return difference is not purely due to the weighting methods but is due to the positive market premium and tax shield. If the market premium is negative or firms in the portfolios are financially distressed, the results may not hold. Investors need to take the market premium and the financial structures of firms into account when they choose weighting methods. Third, the differences with respect to return, volatility, and correlation to the market premium between two weighting methods can be found with as little as 20 equities, or with fewer equities if they have varying market capitalization.
Beyond Cap-Weight: The Search for Efficient Beta
Rob Arnott (Research Affiliates), et al. | Nov. 16, 2009
For practitioners, the elegant simplicity of an equally weighted portfolio is compromised by implementation issues. Because Equal Weight means that we hold small companies on the same scale as large ones, the strategy results in higher transaction costs and lower capacity than Cap Weight. Still, absent trading costs and any view on forecasting return or risk, equal weighting has considerable appeal on a risk-return basis.One nuance that has received startlingly little attention in the academic and practitioner journals is: Equal weighting of what index? If Cap Weight has a bias towards including overvalued companies, then Equal Weight may exacerbate this bias. For instance, a clairvoyant might assert that the future prospects of 150 companies in the S&P 500 do not justify inclusion in the index. Their “clairvoyant value” market cap is too low. Because they will assuredly underperform eventually, they will pull down the S&P 500 return relative to our mythical clairvoyant value.
Equal Weight Indexing: Seven Years Later
Standard & Poor’s | July 2010
Equal weighting is factor indifferent. It randomizes factor mispricing, and is thus an
attractive option for proponents of the theory that the market is inefficient and, at times,
misprices factors… Historically, the S&P Equal Weight Indices have outperformed their market cap weighted equivalents in the long-run. The level of performance has also varied considerably
under different market conditions… The outperformance of the S&P Equal Weight Indices is a result of the differing weighting and rebalancing processes. In terms of risk factor exposures, a complex and dynamic combination of size and style risk factors have contributed to the difference in returns. It may be difficult to replicate equal weighted index return outcomes through a simplistic combination of style and sector indices… Equal weighting demonstrates long term outperformance internationally… Criticism of equal weighted indices has centered on increased turnover and capacity constraints relative to market capitalization weighted indices. While true in abstract theory, neither is a serious hurdle in practice.
Portfolio Return Metric: Equal Weights Versus Value Weights
Kevin C.H. Chiang (University of Alaska) | May 22, 2002
Whereas the existing literature focuses on the relation between weighting schemes and abnormal portfolio return metrics, this study extends the literature and investigates the relation between weighting schemes and raw portfolio return metrics. We show that the equal-weight portfolio return metric systematically yields higher estimates of portfolio returns for event samples than the value-weight portfolio return metric. We also demonstrate that value-weight portfolio return metric can be a biased estimator of the counterpart of the population. These results imply that the commonly used testing procedure based on the matching portfolio method and the Fama-French three factor regression can produce misleading inferences. Several remedies are proposed in this study.
The Effect of Portfolio Weighting on Investment Performance Evaluation: The Case of Actively Managed Mutual Funds
Stanley Block (Texas Christian University) and Dan French (New Mexico State University) | Spring 2002 (Journal of Economics and Finance)
Among the factors influencing investment performance measurement is the weight dedicated to each security. This paper develops metrics for measuring the extent of equal weighting and value weighting of a portfolio. A sample of 506 actively managed mutual funds shows that funds tend to be equally weighted to a greater degree than they are value weighted, implying that investment performance based solely on a single value-weighted benchmark may not adequately identify excess performance. We propose a two-factor model utilizing both a value-weighted and an equally weighted index and show that the model provides a better fit than the singleindex model.
Improving Emerging Market Equity Performance through Equal-Weight Country Indexing
R. McFall Lamm, Jr. (Stelac Advisory Services) | Spring 2011 (Journal of Index Investing)
Capitalization-weight orthodoxy now dominates in the equity indexing world despite the fact that research indicates it is inefficient and underperforms valuation-indifferent approaches. However, a more important issue for multinational indices—especially in the case of emerging markets—is the method used to determine country weights. Pure cap-weighting allows country exposures to indiscriminately fall out of the bottom-up aggregation process, which significantly over-concentrates risk in only a few countries. This study demonstrates that employing an equal country weighting scheme for emerging markets would have hugely outperformed cap-weighting for the past quarter century. Equal weighting reduces risk by increasing diversification across divergent macro policy regimes and is mean–variance optimal in a special case. In contrast, cap-weighting forces investors into riskier exposure to overvalued markets and is mean–variance inefficient. Unfortunately, there are no equal-weighted broad emerging market indices or commercial products available. Using emerging market country ETFs offers a partial solution, although the full range of emerging markets is not covered and liquidity is sometimes limited.