Outperformance in Equal-Weight Indices

INTRODUCTION

Equal-weight indices were among the first non-capitalization-weighted indices to emerge as templates for passive investments, or as benchmarks for the evaluation of active managers.¹ Since their introduction, the concept has been extended to a wide range of markets and market segments, while products tracking equal-weight indices have attracted significant assets.

Exhibit 1 demonstrates one of the drivers of interest in equal-weight indices, namely their outperformance over their capitalization-weighted equivalents in a significant number of global equity markets.

This paper examines the sources of equal-weight index outperformance from various perspectives, including sectoral, factor-based, and constituentlevel analyses, and provides a guide to the potential applications of equalweighted investment strategies in a portfolio context. Highlights include the following.

We show how small size and (anti-) momentum biases typically arise in equal-weight equity indices, and we outline their respective impact on performance.

From a sectoral perspective, we show that—at least in the case of the S&P 500—a majority of historical outperformance was due to equal weighting within sectors, as opposed to differences in sector exposures.

We articulate an argument for equal weighting as a theoretically optimal strategy for return-seeking investors possessing limited stock-picking skills, and we examine the consequences of this perspective for active equity funds.

We illustrate the potential portfolio applications of equal-weight investments, particularly to complement either low-volatility or momentum-based strategies, or as a replacement for active funds.

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