A reader recently sent me a direct message asking whether I had ever evaluated the equal-weighted S&P 500 (RSP) as part of my monthly series on momentum strategies. I thought I would answer this reader's question with an article detailing the outperformance of equal-weighted strategies on both a standalone basis and as part of a momentum strategy.
As this reader noted, I am a strong believer in equal-weighted strategies, and demonstrated earlier this year why I believed that the equal-weighted index would again outperform the capitalization weighted broad market index in 2013. The equal-weighted S&P 500 has meaningfully outperformed the S&P 500 (SPY) over not only 2013, but the trailing generation; owing to the contrarian nature of its rebalancing, which buys stocks that have underperformed and sells stocks that have outperformed to return to equal weighting. This strategy also benefits from gleaning the small cap premium, one of the Fama-French factors, from owning stocks with a lower average market capitalization. The equal-weighted S&P 500 effectively capitalizes on two sources of return, the value premium from its contrarian nature and the size premium from owning smaller cap stocks on average.
The reader's question likely emanated out of the fact that the contrarian nature of equal weighting (buying losers, selling winners) and the alpha generated by momentum (buying winners, selling losers) appears antithetical. The two systematic trading strategies both produce alpha, but over different holding periods. Momentum strategies outperform for periods ranging from just weeks to several months, while contrarian strategies work over longer holding periods.
This hand-off makes intuitive sense. If momentum strategies outperformed over longer time intervals, these stocks would become expensive relative to fundamentals and contrarian investors could sell these stocks short (or conversely buy stocks that have underperformed over long time periods) and earn excess returns over forward periods.
This intuitive juxtaposition of momentum and contrarian investing is supported by academic research. Value investing has been supported as a long-term wealth creator since the 1930s works of Benjamin Graham, former professor of Warren Buffett at Columbia Business School and author of the highly acclaimed "Security Analysis." Equal weighting is a form of value investing as the strategy necessarily buys stocks that have underperformed to return them to their equal weighting at the rebalancing date. Value investing strategies that purchase companies with comparatively low prices to trailing earnings (Dreman 1998) or low prices relative to book value (Fama and French 1992) to produce long-run outperformance have long frequented academic literature.
Demonstrating the long-run efficacy of value investing pictorially, the Russell 1000 Value Index (IWD) has outperformed the Russell 1000 (IWB) by over fifty basis points per annum over the last thirty five years.
Momentum strategies have been demonstrated to produce short-run alpha across asset classes, geographies, and time. The canonical momentum strategy was first authored by Jegadeesh and Timan (1993), which showed that stocks that had performed the best (worst) over trailing three to twelve-month periods continued to perform the best (worst) over forward three to twelve-month periods. On this website, I have demonstrated momentum strategies between domestic stocks and Treasuries, domestic stocks and corporate bonds, domestic stocks and emerging market stocks, between varying ratings cohorts within corporate bonds, value and growth stocks, low volatility and high beta stocks, and a host of other imperfectly correlated asset classes, typically utilizing one to three-month look-back periods and one to three-month forward holding periods. Alpha generative momentum is so pervasive that I sometimes worry that I am authoring too many articles on the topic for my readership.
An equity momentum strategy that owns the equal weighted S&P 500 or the more oft-cited capitalization-weighted S&P 500 based on which index had outperformed in the trailing one month, forward for the next month has historically produced higher average returns with lower variability of returns than buying and holding the broad index. This strategy combines the contrarian value-seeking nature of equal weighting with a momentum overlay that follows the outperforming leg over short intervals. This strategy has produced the following return profile historically:
Equal weighting and momentum do not contradict each other, they absolutely complement each other. First, notice that the equal weighted index has produced higher average returns (left column) than the capitalization-weighted index in each of the historical periods. Next, notice that for periods exceeding three years, the momentum strategy has produced even higher average returns than equal weighting with lower variability of returns. Over the twenty-plus year sample period, the momentum strategy would have produced a compounded cumulative return more than twice that of the S&P 500 with only marginally higher risk.
I have shown in past articles that a strategy that buys the S&P 500 or the broad Treasury index (GOVT) based on which asset class had outperformed in the trailing month, and holds that leg forward for one month has generated tremendous absolute and risk-adjusted outperformance over long time intervals. Substituting the equal weighted index in for the capitalization-weighted S&P 500 further enhances this outperformance. The cumulative return profile of an equal-weighted S&P 500/Treasury switching strategy is even greater than the 12.84% average annual return of the equity momentum strategy covered in this article (with a meaningfully lower variability of returns). If you thought that the average 3.3% annual outperformance of this momentum strategy relative to the S&P 500 was impressive, please follow me and read tomorrow's installment.
Given that this article was driven by reader feedback, please share observations in the comments section below. Thanks for reading.