The Evolution Of Equal Weighting
Over the past few years, market observers have seen increased interest in indexes that use “alternative” weighting methodologies. While market-cap weighting is an excellent choice for benchmarks for active management and for the basis of investable products such as passive mutual funds, exchange-traded funds (ETFs), futures and options, investor interest in alternative index weighting methodologies, such as equal weighting and fundamental weighting, is growing.
In this paper, we provide an overview of some of these alternatives and a broader analysis of equal-weighted indexes. We first describe cap-weighted, fundamental-weighted and equal-weighted indexes and compare their characteristics. We then discuss in greater detail the conventional equal-weighted index structure and review a new alternative to this method: the sector equal-weighted index methodology. We compare and contrast the conventional equal-weighted methodology to the sector equal-weighted indexes and illustrate the benefits that a sector equal-weighted index can provide. We then extend this analysis to the international indexes and analyze whether the characteristics observed in the domestic market persist.
Based on our simulations, we find that:
- Equal weighting by constituents, while simple and transparent, introduces sector risk into an index.
- Sector equal-weighted indexes provided a better absolute return with lower volatility for the time period tested compared to traditional equal-weighted and cap-weighted indexes.
- These results are consistent across the domestic large-cap, mid-cap and small-cap spectrum and the global developed and emerging regions.
Market-cap weighting remains the most popular approach to index construction. Cap-weighting is an objective, practical and theoretically grounded weighting scheme: objective, in that market values represent the market’s assessment of the relative values of firms; practical, given that a portfolio automatically adjusts its constituent weights as market prices move, resulting in fewer rebalancing trades; and theoretically grounded, drawn as it is from Harry Markowitz’s capital asset pricing model.
The capital asset pricing model (CAPM) and the efficient market hypothesis (EMH) provide the theoretical bases for cap-weighted indexes. The efficient market hypothesis1 states that asset prices are rationally priced by all investors, who have equal access to relevant information. Thus, the price of a security (and by inference, its market capitalization) reflects its true value, based upon all available information at any given point in time.
The CAPM designates the aggregation of all assets as being the “market portfolio” and states that the market portfolio is efficient, i.e., that it has the highest level of expected return for its level of risk. According to the CAPM, the market portfolio (which holds risk-free assets in some proportion) is the only risky asset portfolio investors need to invest in.
While there is justifiable debate on the validity of the CAPM, the theory establishes the market portfolio as an important baseline methodology. The assumption that cap-weighted indexes measure the market portfolio has led to their being considered the best proxies for measuring the performance of a market and of active managers, and it forms the theoretical basis for passive index investing (see Christopherson, Cariño, Ferson ).
Over and above the theoretical basis, weighting the constituents of an index by their market capitalization has many practical advantages that appeal to passive investors. Cap-weighted indexes are the only indexes to represent a buy-and-hold strategy and to provide broad market representation at a very low cost within the replicated portfolio. Because they do not require frequent rebalancing, cap-weighted indexes help to keep transaction costs low within the replicated portfolio. Most cap-weighted indexes also have an objective and transparent methodology that is simple to understand, construct and track.
Critics of cap-weighted indexes point to the fact that basing index constituents’ weights on their market capitalization results in the largest securities having the biggest weights in the index, so much so that the contribution of smaller-capitalization securities can be minimal. Passive investment based on cap weighting captures the return of the benchmark. But if investors believe markets are not efficient, they must believe it is possible to earn excess return over the benchmark.
While market-cap weighting is an excellent choice for passive investable products, there is growing interest in alternative index weighting methodologies. Two leading alternative approaches are fundamental-weighted indexes and equal-weighted indexes.