Ferri: The Extra Risks Of Equal Weighting

March 04, 2014

It seems investors can beat the S&P by investing in the S&P, but there's definitely a catch, Rick Ferri says.

It’s easy to beat the S&P 500. Just hold all stocks in the S&P 500 in an equal amount. This “equal weighted” index would have outperformed the cap-weighted S&P by more than 6% annually over the past five years. What’s the trick? Just ignore risk.

There’s more risk in an equal-weighted S&P 500 stock strategy. Once the extra risk is accounted for, the strategy is a zero-sum game. See No Free Lunch From Equal Weight S&P 500 for a detailed explanation.

The extra risk in equal-weighted strategies tends to get shuffled into the background in the hype surrounding this and other so-called Smart Beta Strategies. Research Affiliates (RA) recently published an article in their February newsletter, Fundamentals, that provides an example of this. Here is a quote from their article:; “[W]e find that traditional indexing—and active managers who hug the benchmark (closet indexers)—deliver below-average returns.”

Is this statement true? It depends on what’s meant by “average returns.” To find out, I went to the endnotes of the article, “By definition, broad cap-weighted indices match the return of the market portfolio; that is, the aggregate return of all the stocks held at market weights. In other words, traditional indices deliver the market-weighted average return. They do not, however, deliver the return of the average asset.”

Average return in this case means “average asset” return, which is the simple average return of each stock individually without consideration to the size of each company. It’s a fancy way of saying equal-weighted index. What this definition doesn’t mean is the average investor return or the average actively managed return. Those returns are much lower.

There are problems with using the average asset return as a benchmark for performance. First, there isn’t enough supply of stock available for everyone to equal weight the markets. Second, those who do equal weight accept more risk than those who cap-weight the same stocks.

Let’s assume an index holds two stocks. One is a rock solid $500 billion conglomerate and the other is a $5 million penny stock issued by Rick’s Waffle Shop. In 2013, the conglomerate earned a total return of 4% and Rick’s Waffle Shop had a total return of 100% (I make great waffles). In line with the RA article, the “average asset” has outperformed the cap-weighted index by a whopping margin. The equal weight index return was 52% while the cap-weighted return was only 4% plus a bit more.

A 52% return is more attractive than a 4% return, but is it fair to tell all investors that there’s a free lunch waiting to be served at the Equal Weight Café? I don’t think so.

Let’s assume there are only 1,000 investors in the world with $500 billion in total to invest and that they’ve all bought into equal weighting. A two stock index would require half of the money be invested in the conglomerate and the other half in Rick’s Waffle Shop.

 

 

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