In an ongoing series of articles, I have highlighted seven buy-and-hold strategies that have historically outperformed the S&P 500.
Even after a historic economic expansion, a large number of Americans have failed to participate in the equity market despite falling barriers to entry and lower trading costs.
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 strategies I will cover in this series of articles is "equal weighting," which has outperformed traditional capitalization-weighting over long time intervals.
If you want to go fully passive and own 1 single fund that offers a twist that will be the market on average over time, equal-weighting the constituents in the S&P 500 might be that play. You will own the same 500 stocks as the most commonly referenced benchmark gauge, but in proportions that tilt towards the smaller capitalization stocks and in a vehicle that periodically rebalances to add exposure to underperforming components.
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 fifth strategy - equal weighting - might be the simplest. Instead of weighting the S&P 500 constituents by their market capitalization, weighting those same 500 companies equally has delivered higher long-run returns as pictured below:
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. The Invesco S&P 500 Equal Weight ETF (RSP) replicates this alternative weight index with an expense ratio of 0.20%.
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 30-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 have outperformed capitalization-weighting by 2.8% per annum for a period stretching from 1927 to 2016. Over that long time period, simply equal-weighting the same stock market constituents would have produced cumulative returns that are nearly 10x higher.
In late April 2019, I published Rolling Returns: Equal-Weighted vs. Cap-Weighted that showed that as holding periods extend that equal-weighting is more likely to outperform cap-weighting in a broad subset of the U.S. stock market. Using a 90-year dataset, equal-weighting had outperformed in every rolling 40-year period - roughly the length of time from early adulthood saving to disinvestment during retirement.
Over that full dataset, equal-weighting beat cap-weighting by 2.69% per year, but over the last forty years, that is just 0.82% per year. That begs the question of whether anything has changed. In 2019, the tech heavy cap-weighted index outperformed the equal-weighted index by around 2.2%.
One could hypothesize that the network effects involved in large technology companies encourage "winner take all" markets that lead to relative gains of market cap giants. E-commerce (Amazon; AMZN), internet search (Alphabet; GOOGL), social networking (Facebook; FB), email, and mobile phone operating systems and ecosystems (Apple; AAPL) all encourage this type of market dynamic. Others might argue that lax anti-trust regulation has allowed for the creation of market giants that have benefited cap-weighting like never before. Globalization that has seen U.S. multinationals dominate could also be driving relative gains of mega caps.
While cap-weighted giants have seen strong relative gains over the back half of this current economic cycle, this time is likely no different. In Why Does an Equal-Weighted Portfolio Outperform Value and Price-Weighted Portfolios, authors Yuliya Plyakha, Raman Uppal, and Grigory Vilkov confirmed in 2012 that "that the equal-weighted portfolio outperforms the value- and price-weighted portfolios partly because of its higher exposure to the market, size, and value risk factors." The authors also added that equal-weighting generates alpha, "whose source is the portfolio's monthly rebalancing that takes advantage of reversal, idiosyncratic volatility, and the lead-lag characteristics of stock returns at the monthly frequency."
I hope this article helps Seeking Alpha readers frame the relative performance of equal-weighting through a historical lens. Over long-time intervals, I still believe that equal-weighting has a better chance of capturing structural alpha (size and value) and will produce higher returns than the typical cap-weighted index. This traditional strategy may not be smart beta, but for long-term buy-and-hold investors, it may just be smart.
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. 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.