The Evolution Of Equal Weighting

December 15, 2010

The Russell Equal Weight Indexes
The conventional approach to the construction of equal-weighted indexes, however, brings with it issues such as inherent sector biases, potential capacity constraints/liquidity concerns, high turnover and rebalancing issues.

Sector Biases
An index with equal weights across all constituents (constituent equal weighting: CEW) will allocate significantly higher weights to some sectors than to others, embedding sector bias into the index.

An alternative approach is to equal-weight sectors within an index. Figure 2 compares the sector weights of the Russell 1000 cap-weighted index, the Russell 1000 CEW index and the Russell 1000 SEW index as of January 1, 2010. The technology, financial services and health care segments dominate the market-cap-weighted index, while financial services, producer durables and consumer discretionary sectors dominate the conventional equal-weighted variant, accounting for more than 50 percent of the index. The SEW approach evens this out, placing equal weights on each segment of the market.

Figure 2

Russell’s sector equal-weighted indexes allocate an equal portion of the portfolio to each of the nine Russell sectors, and then equal-weight the constituents within each sector.

Why Equal-Weight Constituents Within The Sector?
Equal-weighting the constituents within a sector assures that a few large companies will not drive the performance of the sector. This may also add diversification benefits similar to those outlined above for equally weighted sectors. To test this, we simulate a portfolio that is equal-weighted at the sector level, but the constituents within each sector are weighted according to their float-adjusted market capitalization (SEW-MC). Rolling 36-month correlations between the SEW-MC, SEW and the cap-weighted Russell 2000 Index are presented in Figure 3.

Figure 3

The results are surprising. The correlation between the SEW index and the Russell 2000 falls dramatically during the technology boom-and-bust period, dropping as low as 60 percent on August 2001 and maintaining a correlation of 90 percent to 95 percent after May 2003. The correlation of the SEW-MC index to the Russell 2000 stays above 95 percent through the whole period.

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