5 Ways To Beat The Market In 2017 And Beyond: Part V

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Summary

Culminating in this final piece of the series, I have highlighted five buy-and-hold strategies that have historically outperformed the S&P 500.

Stock ownership by U.S. households is low and falling, even as the barriers to entering the market have been reduced. Improved financial literacy is a motivator for my authorship.

Investors should understand simple and easy to implement strategies that have been shown to outperform the market over long time intervals.

The fifth of these five strategies I will revisit in this series of articles is "equal weight", which has outperformed traditional capitalization-weighting over long-time intervals.

The strategies I have discussed in this series thus far (size, value, low volatility, dividend growth) are all low cost ways of getting broadly diversified domestic equity exposure with factor tilts that have generated long-run structural alpha. The final strategy - equal weighting - might be the simplest. Instead of weighting the S&P 500 constituents by their market capitalization, equal-weighting these same 500 companies has delivered higher long-run returns as pictured below.

Equal Weighting

The S&P 500 Equal Weight Index is a version of the S&P 500 where the constituents are equal-weighted as opposed to the traditional market capitalization weighting of the benchmark gauge. Guggenheim S&P 500 Equal Weight ETF (NYSEARCA:RSP) replicates this alternative weight index with an expense ratio of 0.40%. When the equal-weighted version of the index is rebalanced quarterly to return to equal weights, constituents which have underperformed are purchased and constituents which have outperformed are reduced, a contrarian value strategy that has produced excess returns relative to the capitalization-weighted S&P 500 index over long time intervals. Equal-weighting also gives an investor a greater average exposure to smaller capitalization stocks, a risk factor, detailed in the first article in this series, for which investors have historically been compensated with higher average returns. The composition of the equal-weighted index is more consistent with mid-cap stocks, which have historically outperformed large caps.

While this first graph shows a 27-year history of outperformance by the S&P 500 Equal Weight Index, I have examined equal-weighting versus capitalization-weighting over even longer time horizons. In "Very Long-Term Excess Returns From Equal-Weighting", I demonstrated that equal-weighting U.S. stocks has outperformed capitalization-weighting by 2.81% per annum for a period stretching over ninety years. While the logarithmic graph below might mask some of this outperformance to some readers, the higher average returns of equal-weighting actually produces 9-10x more money cumulatively over this long time horizon - a powerful statement on long-run performance.

This outperformance was repeated in 2016 as the equal-weight index again outperformed the S&P 500 as pictured below. Like we saw in small-cap stocks and value stocks, equal-weighting increased its outpeformance versus capitalization-weighting post-election.

Research by Plyakha, Uppal, and Vilkov (2012) puts some data behind my narrative that the size factor and contrarian rebalancing drive alpha in equal weighting strategies. Their analysis found that the higher systematic return of equal weighting relative to capitalization-weighted portfolios arose from relatively higher exposure to the size and value factors described in the first two articles in this series. In the aforementioned academic research, the higher alpha of the equal-weighted strategy was determined to arise from periodic rebalancing, a contrarian strategy that exploits time-series properties of stock returns.

Some of the most powerful ideas in finance are the easiest and simplest to implement. At its core, equal weighting overcomes the bias inherent in the capitalization-weighted benchmark index that forces investors to hold larger proportions of stocks that have risen in value.

Periodic rebalancing allows the strategy to "buy low and sell high," still the most tried and true way of making money long term in financial markets. Each of the five strategies I have outlined in this series shares this notion that sometimes the best ideas are the simplest. I hope long-term buy-and-hold investors consider the size, value, low volatility, consistent dividend growth, and equal weighting approaches that have been demonstrated to outperform the market. Each of these factor tilts gleans their outperformance from slightly different risk factors, which should generate risk-adjusted outperformance over multiple business cycles. Low volatility will have better performance in the downturn, the size and value factors should generate outperformance in a recovery.

The performance of the five exchange-traded funds referenced in this series are compared with the broad market gauge for 2016 in the table below:

Four of these strategies - value (NYSEARCA:RPV), low volatility (NYSEARCA:SPLV), dividend aristocrats (BATS:NOBL), and equal weighting (NYSEARCA:RSP) - are all alternative-weighting schemes of the broader index, which makes the fact that these factor tilts have generated this level of outperformance versus the broader market all the more impressive.

Thanks to all of the new followers who have read this series and joined our mission to understand and capture the sources of structural alpha available in the market. In the coming days, I hope to publish a few articles on pairs of these factor tilts that work uniquely well in tandem.

Disclaimer:

My articles may contain statements and projections that are forward-looking in nature, and therefore inherently subject to numerous risks, uncertainties and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance, and investment horizon.

Disclosure: I am/we are long RSP, SPY, IJR, RPV, NOBL, SPLV.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.