Exploring the Benefits of Equal Weight vs. Cap Weighted Investments: Understanding Occasional Underperformance and Examples
Most iQUANT investment models use equal weighting.
Equal weighting investing is an investment strategy in which all the securities or stocks in a given strategy or portfolio are assigned equal weight. In a traditional market-capitalization-weighted index, larger companies with higher market capitalizations have a greater impact on the index's performance. However, in an equal-weighted index, each stock has the same influence regardless of its market capitalization.
“Equal-weight portfolios have tended to outperform market-cap-weighted portfolios over time.”
Due to its capacity to increase exposure to smaller businesses and the potential for higher returns from their growth, equal weighting has outperformed market capitalization weighting over the long term, though it has occasionally underperformed its cap-weight peers.
Below we delve into the benefits of equal-weighted investments, discuss occasional underperformance, and provide real-world examples to illustrate these concepts.
Diversification and Risk Mitigation:
Compared to cap-weighted strategies, equal-weighted investments offer improved diversification. They minimize concentration risk and guarantee a wider exposure across the portfolio by allocating an equal amount to each holding. By increasing risk-adjusted returns, this diversification can lessen the impact of any particular underperforming stocks.
Example: Suppose a cap-weighted investment allocates a significant portion to a single stock, which subsequently experiences a significant decline. The overall portfolio performance may be negatively affected. In contrast, an equal-weighted portfolio would allocate the same percentage to each holding, reducing the impact of any single stock's underperformance on the overall portfolio.
Potential for Outperformance:
During certain market conditions, equal-weighted investments have the potential to outperform cap-weighted strategies. They provide exposure to smaller or undervalued companies with the potential for rapid growth by assigning equal weight to each holding. This strategy can take advantage of the opportunities presented by these stocks, potentially resulting in higher returns.
Example: During periods of economic recovery, smaller companies with growth potential may experience faster expansion compared to larger, more established firms. An equal-weighted portfolio would provide increased exposure to these smaller companies, potentially leading to outperformance when compared to a cap-weighted portfolio that may be more heavily weighted towards larger companies.
Rebalancing and Discipline:
Equal-weighted portfolios frequently require rebalancing. To maintain an equal weight distribution, this process entails selling appreciated stocks and buying underperforming ones. Rebalancing helps investors maintain discipline and stick to their investment strategy by avoiding emotional or speculative decisions based on short-term market trends.
Example: Let's say a particular stock within an equal-weighted portfolio experiences significant price appreciation, causing it to have a larger weight than intended. During the rebalancing process, the excess gains from that stock would be sold and reallocated to other holdings, ensuring adherence to the equal-weighted strategy.
Long-Term Performance Potential:
While equal-weighted investments may underperform cap-weighted strategies on occasion, they have the potential for strong long-term performance. Equal-weighted portfolios can capture broader market movements and potentially benefit from the growth of smaller companies that may become future market leaders by avoiding excessive concentration in a few large-cap stocks.
Example: Historical data shows that equal-weighted strategies have occasionally underperformed during extended periods of market dominance by a few large-cap stocks. However, over longer time horizons, equal-weighted portfolios have demonstrated the ability to generate higher returns and provide exposure to a wider range of stocks.
Conclusion:
While there have been periods of underperformance, equal weight investments have demonstrated the potential to outperform cap weight investments over the long term. By providing broader exposure to smaller and potentially undervalued companies, equal weight strategies can capture the growth potential of these stocks. This approach avoids excessive concentration in a few large-cap stocks, allowing for a more balanced and potentially higher-return portfolio.