The Problem with Equal Weight Index Funds

Equal Weight Index Funds: A Detailed Analysis

Key Concepts:

• Market Capitalization Weighting: Index weighting based on a company’s total market value.
• Equal Weighting: Assigning the same weight to each stock in an index, regardless of market capitalization.
• Factor Exposure: Sensitivity of a portfolio to specific investment characteristics (e.g., size, value, momentum).
• Turnover: The rate at which securities are bought and sold within a portfolio.
• Momentum: The tendency of assets that have performed well recently to continue performing well.
• Multifactor Regression: A statistical technique used to identify the drivers of a fund’s returns.

Introduction & Historical Performance

Ben Felix, CIO of PWL Capital, addresses the frequent inquiries regarding equal weight index funds. While acknowledging their appealing aspects – particularly in the current market environment of high concentration and valuations – he argues they are not inherently superior and come with unique drawbacks. Historically, equal weight indexes have outperformed market capitalization weighted indexes over decades, with the Invesco S&P 500 Equal Weight ETF exceeding the S&P 500’s performance since its 2003 inception, albeit by a small margin. However, Felix emphasizes the importance of understanding the trade-offs and contextualizing past performance.

Market Capitalization vs. Equal Weighting: Core Differences

The fundamental difference lies in weighting methodology. Market capitalization weighting assigns portfolio weights based on a company’s size (total market value of its shares – e.g., Apple or Shopify). This approach is considered “passive” as it allows the market to dictate weights. Equal weighting, conversely, assigns identical weights to all stocks within the index, irrespective of their market capitalization. This results in significantly different portfolio compositions. Market cap weighting doesn’t require frequent rebalancing, as it naturally adjusts with market movements.

Concerns with Market Capitalization Weighting & the Appeal of Equal Weighting

A perceived problem with market cap weighting is the potential for high concentration in a few dominant stocks, a situation currently pronounced in the US market. While concentration fluctuates naturally, equal weighting avoids this by design, preventing excessive allocation to a small number of companies. Equal weighting’s appeal is further enhanced by current high US stock valuations, as it inherently tilts away from the largest, most expensive stocks, potentially leading to better future returns.

Risks and Inefficiencies of Equal Weighting

Despite the benefits, Felix argues equal weighting introduces its own risks. He posits that the extreme over and underweights in an equal weighted portfolio may be riskier than accepting concentration in larger companies within a market cap weighted portfolio. This risk manifests in two primary ways:

• Higher Volatility: The 15-year standard deviation of an S&P 500 equal weight ETF is demonstrably higher than that of a market cap weighted S&P 500 ETF.
• Factor Exposure: Equal weighting results in increased exposure to factors like small-cap and value stocks, which are theoretically considered riskier by the market.

Rebalancing Costs & Negative Momentum

Equal weighted indexes require significantly more frequent rebalancing. As smaller companies grow, the fund must sell down their position to maintain equal weights, and vice versa. The S&P 500 Equal Weight ETF has an average annual turnover rate over 10 times higher than a market cap weighted S&P 500 ETF, incurring substantial trading costs.

Crucially, equal weighting is inherently a negative momentum strategy. It systematically sells stocks that have recently performed well (and thus grown in weight) and buys those that have performed poorly. Jagadish and Titman’s 1993 study established the momentum effect – the tendency of recent winners to continue winning and losers to continue losing. Multifactor regression analysis of the S&P 500 Equal Weight ETF confirms a positive loading on the size and value factors, and a negative loading on the momentum factor.

A More Efficient Approach: Intentional Factor Tilts

Felix contends that the benefits of equal weighting – exposure to smaller and cheaper stocks – can be achieved more efficiently through intentional factor tilts. He highlights Dimensional Fund Advisors (DFA) as an example. The Dimensional US Core Equity One Fund exhibits similar exposure to small-cap and value factors as the equal weight S&P 500 ETF, but avoids the drawbacks of equal weighting.

Specifically, Dimensional:

• Limits Sector Divergence: Caps sector weight differences to avoid large, potentially incorrect, sector bets.
• Avoids Trading Against Momentum: Implements rules to avoid selling recent winners and buying recent losers.
• Maintains Lower Turnover: Uses market cap weights as a starting point, minimizing unnecessary rebalancing.

The Dimensional Fund has a net expense ratio of 0.15%, comparable to the 0.2% of the equal weight S&P 500 ETF.

Performance Comparison & Long-Term Data

Since its 2005 launch, the Dimensional Core Equity One Fund has outperformed the equal weight S&P 500 ETF, likely due to strong performance of large, high-priced stocks during that period. Backtesting data from 1971 shows the equal weight S&P 500 index performing well, largely due to exposure to small-cap and value stocks and negative momentum exposure. A backtested Dimensional US Core Equity 1 index performed nearly identically to the equal weight index, but with lower volatility. Felix cautions that backtesting data is unreliable and should be interpreted with skepticism.

Conclusion

While equal weight index funds appear attractive due to current market conditions and historical performance, they introduce significant risks and inefficiencies. The benefits – exposure to smaller and cheaper stocks – can be achieved more effectively through intentional factor tilts, as demonstrated by Dimensional Fund Advisors. The key takeaway is to focus on why equal weighting has performed well, rather than simply replicating the weighting scheme itself. Felix clarifies that he has no financial relationship with Dimensional, though his firm PWL Capital utilizes their Canadian products.