Equal-Weighting: An Alternative To The Standard Index

Equal-Weight Indices Drawbacks

There are two main reasons that stop equal-weight indices from being widely adopted for passive capital deployment.

The first is that for large capital allocators, equal-weighted indices have high friction costs due to liquidity constraints. Contrast that to a market capitalized index where the largest amount of capital is being directed towards companies most able to handle that inflow.

For example, Apple’s market capitalization is $741 billion while Torchmark Corp (also in the S&P 500) is only $8.2 billion. If a large pension fund or one of the big retail S&P 500 ETFs were to suddenly shift to an equal weighted index, that would mean these clients would be buying the same dollar value of Torchmark as of Apple. This is impractical for large pools of capital. The big money has *no choice* but to be invested in market capitalized indices. There is no other way to put that much capital to work without substantial liquidity penalties that would outweigh the benefits.

The second reason that investors and allocators, even those managing smaller pools of capital, don’t buy equal-weighted indices is tracking risk. Think back to the year 2000 TSX example. At one point the equal-weighted index had underperformed by more than 50%. It is difficult for *investors* to deal with that sort of underperformance. Although this is an extreme example, there have been (and will continue to be) *long periods when equal-weighted returns less than market-cap weighted.*

Look at the S&P 500 since the beginning of 2017. As the FANG stocks took off, the spread between the market-cap index and the equal-weight index exploded higher.

At the top of the market in late September, the S&P 500 market-cap index was up almost 35% while the equal-weight index was only at 26%. This 700 basis points came quickly and even now that the FANG stocks have sold off, the market-capitalization based index is still 6.5% ahead since the beginning of 2017. The volatility in the relative performance between the two indices creates an environment where investors or allocators doubt the strategy.

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Disclosure: None.

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