The Evolution Of Equal Weighting

December 15, 2010

We do not see a big drop in correlations during the 2008-2009 financial crisis, and a closer look at the sector volatility of the Russell 2000 explains why. We calculate the volatility of the sector returns of the Russell 2000 index for two periods, 1998 to 2000 and 2007 to 2009. For the 1998-2000 period, volatility is high in the energy, health care and technology sectors, while the other sectors have relatively low volatility. For the 2007-2009 period, volatility is spread out across all sectors, with just the energy sector comparatively higher than the other sectors (see Figure 4). This suggests that during periods where volatility is increasing within a few sectors, the SEW index could potentially provide diversification benefits when used in conjunction with cap-weighted indexes. We note that equal-weighting the constituents within sectors adds attractive diversification features to the index, and that simply equal-weighting the sectors does not replicate an SEW index.

Figure 4

Capacity Constraints
Equal-weighted indexes have been criticized for the capacity constraints potentially posed by constituents that are too small to take an equal position. Other concerns focus on high turnover caused by frequent rebalancing. These problems can be eliminated or mitigated in the construction and maintenance of the equal-weighted index.

To address one of the main criticisms of equal-weighted indexes—that an investor can take a significant position within a smaller-capitalization security, posing a liquidity risk—the Russell Sector Equal Weight Index methodology applies a screen prior to the construction of each index, which is designed to remove securities that could have difficulty assuming their required positions in a particular security.

This screen has an insignificant impact on the returns of the index. For the period 1996 to 2010, the Russell 1000 SEW index with a capacity screen applied had an annualized tracking error of only 28 basis points to the same index with no capacity screen applied. For the small-cap Russell 2000 SEW index, the annualized tracking error was 38 basis points.

While portfolio turnover can be a concern with equal-weighted indexes, it is helpful to remember that much of this turnover can be attributed to the reconstitution of the associated cap-weighted index. The average quarterly turnover on the Russell 1000 Sector Equal Weight Index was 6.3 percent for the July 1996 to June 2010 period. However, when we remove the July period of each year (when reconstitution of the cap-weighted Russell 1000 Index occurs), the average turnover becomes 4.2 percent. This suggests that the reconstitution of the underlying index can have a significant influence on the turnover observed in the equal-weighted index. Even when the reconstitution period for the underlying index is taken into account, the portfolio turnover observed in the Russell 1000 Sector Equal Weight Index is comparable to those of equal-weighted indexes currently in the marketplace and certainly lower than the turnover observed in active funds.

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