The Evolution Of Equal Weighting

December 15, 2010

Again, we see similar results in the Russell 2000 SEW index from 2000 to 2010. The energy sector provides the largest contribution, at 26.8 percent, while the utilities sector has the only negative contribution. The financial services sector performs the best within the Russell 2000 cap-weighted index, with a contribution of 22.7 percent, larger than that of the Russell 2000 SEW index.

There are some interesting results we should consider from the sector contributions, particularly the large deviation in the technology sector from 2000 to 2010 for both the Russell 1000 and the Russell 2000. The differences in contribution to return cannot entirely be attributed to the sector weight differences or the different rebalance schemes. We provide the contribution to return by deciles in Figure 14 for the Russell 1000 cap-weighted index. The large negative contribution of -22.58 percent from the top 10 percent of the largest companies in the index played a significant role in the index achieving a negative return for this time period.

Figure 14

The Fama-French regression analysis showed the large influence of smaller-capitalization securities in the SEW index. We surmise from these results that the outperformance of smaller-capitalization securities and the underperformance of large-cap companies led to the SEW index outperformance from 2000 to 2010. This suggests that when larger-cap companies outperform smaller-cap companies, the SEW index might underperform a cap-weighted index.

Equal-weighting by constituents, while simple, introduces sector risk into an index exposure. We find that the sector equal-weighted indexes provided a better absolute return with lower volatility for the time period tested. On the basis of simulated returns, we find that equal-weighting by sector provided better risk-adjusted returns than a constituent equal-weighted index and the respective cap-weighted index over our sample periods. These results are consistent across the domestic large-cap and small-cap spectrum and the global developed and emerging markets, although that analysis was not included in the results. The analysis of the performance attribution and regression shows that the sector equal-weight index is strongly influenced by small-capitalization securities in the index, suggesting that the sector equal-weighted index might underperform a cap-weighted index when larger-capitalization securities outperform smaller-capitalization companies.

1 There are three forms of the EMH: The weak form asserts that all past information is fully reflected in the price of a security. The semi-strong form asserts that all publicly available information is fully reflected in the price of a security. The strong form asserts that all information is reflected in the price of a security.

2 The float-adjusted market capitalization of a stock is the total market capitalization net of closely held shares that are not freely available to the public.

3 Tracking error is calculated as the standard deviation of monthly excess return over the daily reweighted portfolio multiplied by the square root of 12.

4 Turnover is the average turnover (calculated as the minimum of the addition and deletion percentage of the portfolio) per time frame multiplied by the number of times the portfolio is reweighted per annum.

5 The returns of the Sector Equal Weight and the Constituent Equal Weight indexes are simulated and the constituents are not screened for capacity constraints.

Find your next ETF

Reset All