INSIGHTS Market Insight

For most investment strategies, how to weight securities in a portfolio is a fundamental design decision. The entire active management industry is premised on the underlying principle that deviating from capitalization weighting adds value, thus justifying a management fee. Two common approaches in listed equity markets are absolute weighting decisions (an equal-weight starting point) or relative ones (a capitalization-weight starting point).

We at Arabesque Asset Management, as evidence-based, systematic investors, are disciples of the former.

The evidence suggests that equal-weighting decisions (absolute) have, over the long-run, been superior to capitalization-weighted (relative) ones (Banz, 1981; Amihud, 2002). This is highlighted in Fig.1 that shows the S&P 500 equal weighted (S&P EW) outperforming the S&P 500 capitalization weighted (S&P) since 1990 by c. 1.3% p.a. However, this long-term observation is subject to short-term deviations.

During times of concentrated market leadership, such as when the weight of the top 5 stocks in the S&P 500 spikes, the capitalization approach triumphs. For example, during the tech bubble in the late 1990’s tech companies surged, driving much of the index returns, and rapidly increasing in weight. This in turn, lead to the S&P outperforming the S&P EW by 6.2% p.a. in the years 1995-99.

However, when this bubble eventually unwound in 2000, the S&P EW came roaring back, posting an average of 10.7% p.a. outperformance over its cap-weighted counterpart in the 5 years subsequent.

Diversification, diversification, diversification; capitalization-weighted construction will pull you into corners of the market when they surge, such as during the tech bubble. Then of course, when these bubbles unwind, the diversification benefits of the equal-weighted approach will come to the rescue; it is of course the only free lunch in finance.

Whilst we refrain from making predictions, the extreme concentration of the S&P 500 following the megacap surge over the past 3 years is hard to ignore. The top 5 stocks now account for over 20% of S&P 500 weight. Should a broader market recovery ensue on the back of the Covid-19 recovery, then good things may just come to those that equal-weight…

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