Wanna Outdo The Market? Reweight It

What’s evident from the daily chart of normalized closing prices is that alternatively weighted versions of the S&P 500 portfolio outperformed the capitalization-weighted index fund. Drawdowns, however, tended to be deeper for the alt funds. That extra volatility drags RSP’s and RWL’s Sharpe ratio below SPY’s. That’s reflected in the alt funds’ negative alpha coefficients, though expense ratios also figure into that number.

What’s most notable from the table are the differences in the funds’ active shares. Active share measures the difference in a fund’s holdings versus the benchmark. Since all the S&P funds hold the same stocks as the index, any active share must be attributable to the overweights or underweights relative to the benchmark.

Fully 94 percent of RSP’s holdings are identical to the S&P 500, while only two thirds of the RWL mirrors the index. Clearly, RSP gets more bang out of its reweighting than RWL.

To see how, you need to do some factor diving.

Over the past five years, SPY’s returns have been driven primarily by momentum. That’s mostly an artifact of its capitalization weighting scheme. RSP, on the other hand, is a low-momentum play because each of its issues is equal-weighted regardless of its popularity. The sometimes-dramatic reweighting of RSP’s components also makes its portfolio more volatile than the benchmark.   

Like RSP, RWC is a low-momentum portfolio, but instead of being driven by volatility, the Oppenheimer ETF’s powered by value. Given the fund’s revenue weighting scheme, this should not come as a surprise. 

So, which of the two—RSP or RWL—is the better riff on the S&P 500 Index? Well, if we take each fund’s excess average annual return (earned over SPY’s) and divide it its expense ratio, we can readily determine each portfolio’s cost efficiency. RSP, with a factor of 1.00 (20 basis points divided by 20 basis points), plainly comes out on top. RWL’s factor is -0.13.

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Disclosure: Brad Zigler pens Wealthmanagement.com's Alternative Insights newsletter. Formerly, he headed up marketing and research for the Pacific Exchange's (now NYSE Arca) option ...

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