Equal-Weighting: An Alternative To The Standard Index

Although the market-cap index did reflect the appreciation in the Canadian stock market as a whole, was it prudent for a fiduciary to invest in an index almost half of which rested on the fate of one company? For Canadian equity managers, it was an awful choice. Common sense would dictate that passively replicating the TSE 300 was an irresponsible decision yet as Nortel continued to soar, those managers who had done the “right thing” by underweighting Nortel were dramatically underperforming the index.

Herein lies the problem with market based indices. They are subject to the madness of crowds.

Have a look at this chart of the TSX 60 market cap index (orange line, here used as a proxy for the market-cap weighted TSE 300 index) versus the TSX 60 Equal Weighed index (gray line).

From late 1999 to the height of the Dotcom bubble in early 2000, the Nortel-heavy TSX 60 index rallied over 65% while the equal weighted index was up only 15%. Yet by the end of 2002 the TSX 60 index had given up all its gains and was now down 5% while the TSX 60 Equal-Weighted index had edged higher for a total return of 20%.

Obviously this made-in-Canada example is extreme. Rarely do individual companies represent such a large portion of an index.

The outstanding quant shop Research Affiliates has done an extensive study on market capitalized indices versus equal weighted throughout the world. For a detailed analysis, please see here.

We have summarized their findings into this chart:

As you will notice, for most countries, the equal-weighted indices outperformed their market-capitalization based counterparts.

What’s interesting is that when you dig into the data, this outperformance does not come at a cost of higher volatility.

In fact, on average, the equal-weighted indices outperformed by almost 100 basis points with 20 basis points less volatility.

The next question the sharp reader will ask is “if this strategy is so obviously better, why doesn’t everyone employ it?”

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Disclosure: None.

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