By Aye Soe
In a prior blog, we demonstrated that the S&P 500® Equal Weight Index was a more difficult benchmark to outperform than the S&P 500 over intermediate- to long-term investment horizons. In this blog post, we examine the underlying factor exposures of the S&P 500 Equal Weight Index to evaluate the performance of large-cap managers.
As a starting point, we should note that by deviating from market-cap weighting, an equal-weight index generally displays a small-cap bias, value tilt, and higher portfolio volatility than a broad market-cap-weighted index. For example, the annualized volatility of the S&P 500 Equal Weight Index was 15.81% versus that of the S&P 500 at 14.18%.
Next, to determine the underlying factor exposures of the indices, we regress the monthly returns of the two indices against the Fama-French factors' returns, specifically the size, value, and momentum factors. We can see that the S&P 500 Equal Weight Index had higher exposure to the size and value factors and higher negative exposure to the momentum factor (see Exhibit 1) compared with its market-cap-weighted counterpart, the S&P 500.
All the factor coefficients were statistically significant at a 95% confidence level, with the exception of the size factor. These findings were not surprising, as several studies have noted similar results. A research paper by S&P Dow Jones Indices reached a comparable conclusion where the size and momentum factors acted as key drivers of the S&P 500 Equal Weight's excess returns.
Understanding the factor exposures of the S&P 500 Equal Weight Index allows us to consider a possible framework in which we can potentially evaluate the performance of large-cap active managers on a style-adjusted basis. To be fair, actively managed large-cap funds in our study generally benchmarked themselves against a market-cap-weighted large-cap index, such as the S&P 500 or the Russell 1000. Therefore, one can argue that the S&P 500 Equal Weight Index is not a natural benchmark for these managers, and that they are not managing their portfolios to deliver excess returns over the S&P 500 Equal Weight Index.
However, to the extent that a large-cap manager has an investment process to seek value exposure (or avoid overpaying in general) and to construct a well-diversified portfolio that reduces concentration risk, the underlying risk properties of the S&P 500 Equal Weight Index can be matched up against his/her portfolio. Therefore, we propose that the S&P 500 Equal Weight can serve as a secondary or a supplementary benchmark to the market-cap-weighted S&P 500 to measure the effectiveness of the strategy.
 The annualized volatility is from Jan. 31, 1990 to May 31, 2018.
 Edwards, T., Lazzara, C., Preston, H., and Pestalozzi, O. "Outperformance in Equal-Weight Indices." S&P Dow Jones Indices LLC. January 2018.