I was recently asked my opinion on equal-weighted indexes relative to capitalization-weighted indexes. Specifically, I was asked whether they add alpha. As it’s a frequently asked question, and because there are lots of assets invested in equal-weighted funds, I thought I would write about the issue.
John McQuown, then at Wells Fargo, created one of the first index funds for the bank’s pension fund, in the early 1970s. In doing the research, he found that equal-weighting the stocks got higher returns.
However, he concluded at the time that if he tried to run the fund with equal weights, the transaction costs needed to maintain the equal weighting would quickly eat up any advantage. On the other hand, with a cap-weighted strategy, the market does the heavy lifting in terms of rebalancing.
Another important point is that there is nothing “magic” about equal-weighting an index rather than cap-weighting it. The net effect is that you wind up with an index tilted more toward small-cap and value companies. Thus, it shouldn’t be a surprise that an equal-weighted index outperforms a cap-weighted index.
But whether an equal-weighted index adds alpha is a very different question. To help answer it, I’ll examine the returns of three equal-weighted ETFs using the regression tool available at Portfolio Visualizer.
I’ll begin with the largest of the three, the Guggenheim S&P 500 Equal Weight ETF (RSP), with about $13.5 billion of assets as of June 9. For the period June 2003 through April 2017, the fund produced a Fama-French three-factor (beta, size and value) alpha of 0.46 basis points per month (0.06% per annum) with a t-stat of 0.07 (not even close to being statistically significant).
However, the fund did load 0.11 on size and 0.10 on value, indicating it has a tilt toward small-cap and value stocks. In addition, unsurprisingly given the higher weighting on small stocks, the fund had a market beta loading of 1.09. The r-squared figure was 97%, indicating the high explanatory power of the model.
In other words, there is nothing really unique about equal-weighting. And it isn’t “smart beta” either. It’s basically just providing exposure to the size and value factors.