Wednesday, February 09, 2011

Equal Weight Index Funds and the Sin of Portfolio Management

Josh Brown pointed his readers toward an intelligent WSJ article about the trend toward equal weighted index funds.  As a refresher - indices like the S&P 500 are market cap weighted - indexers own shares in proportion to the market caps of the companies.  This obviously results in index performance that is dominated by the performance of the larger companies, which have larger component weights.

As a "remedy" to this phenomenon, index providers are starting to roll out "equal weight" versions of these same indices.  In the NDX - Nasdaq 100 - for example, which is a modified cap-weighted index, the top handful of components dominate the index (rough weights as of today):

AAPL: 20%
GOOG: 4.7%
QCOM 4.5%
MSFT 4.1%
ORCL 3.1%
AMZN: 2.5%
CSCO: 2.4%
INTC: 2%
TEVA: 2%

That's roughly 47% of the index made up of only the top 10 names.

In an equal weighted Nasdaq-100 basket, however, each component would get a 1% weight, and the smaller companies have a significantly higher impact than they do in the modified cap weighted (ie, "regular") NDX.  The top 10 names would make up 10% of the index (after a rebalancing).

The thing that strikes me as most unsavory about the equal weighted indices, though, is their rebalancing schedule.  The funds generally rebalance quarterly to get back to the equal weightings - selling the stocks that have appreciated, and buying more of the stocks that have depreciated.  To me, that reeks of one of the cardinal portfolio management mistakes that every new trader learns at some point - hopefully as quickly as possible:  you don't want to sell your winners and let your losers run, and you don't want to sell your winners and increase positions in your losers. 

That's not to say that equal weight indices will perform worse than their market cap weighted counterparts - I'll get to that in a minute - but rather, that I'd prefer it if the equal weight funds rebalanced less frequently.  If the rebalancings occurred annually, or even bi-annually, it would give the winners a chance to run a little bit, while at the same time making sure that the weights don't get so out of whack that a few big boys dominate the index.   In other words, I think that an improvement to equal weight funds could be "slow rebalance equal weight funds" that don't constantly trim their winners and re-load on their losers.

So how do the equal weights perform vs. the cap weights? It shouldn't be hard to deduce that when smaller cap stocks are outperforming, the equal weight indices will do better - since they give larger relative weightings to the smaller capitalization companies.  Similarly, when large caps are outperforming, the market cap weighted ("regular") indices should do better.

We'll keep an eye on the equal-weight fund sector and watch how their assets grow.  As the WSJ article notes, the $40B in ETFs tracking alternative indices is a small fraction of the $1.8 Trillion in traditional index products.

ps - to my Grammar Ninjas - do you prefer the word "indexes" or "indices?"  I have always used "indices" - is one more correct that the other?


Anonymous said...

I don't think the rebalancing frequency will change the picture - it only affects the transaction costs. Given the "size effect" equally weighted fonds will perform, on average, better. This paper implies that this is due to higher risk:

Kid Dynamite said...

@verloregeneration: I started to write in the post about how the bulk of your returns will come from catching a big bull market - momentum, not mean reversion - but I deleted it because I didn't want to confused issues. In bouncing markets (mean reversion, I mean - up and then down) - you want the frequent rebals. In trending (up) markets, you want to let your winners run... I have written previously about fat positive tails, which is what we're really trying to capture:

Jefferson@Morinda said...

I think this begs the next question; how does an investor take advantage of these two different methodologies?

A "relatively" simple switching strategy between a cap-weighted index and it's equal-weighted counterpart can provide a sometimes dramatic difference in returns vs buying and holding either index. As one would imagine, the 90's tended to favor the cap-weighted approach, remember the 4 horsemen? The 2000's in contrast saw much broader participation in equity mkts, and performance of the equal-weight method show it.

From 1/1/90 thru 12/31/99 the SPX (not incld dividends) was up 315.75% while the SPX Eq Wt was up 224.24%. 1/1/00 thru 12/31/09, the numbers are -24.10% SPX vs +39.52% SPX Eq Wt.

A relative strength switching strategy, using a 3.25% scale on a point & figure chart comparing SPY to RSP, and holding the favored index ETF results in even larger return differences. From 1/5/94 to 5/10/00 SPY favored and returned
195.45% vs RSP ret 122.87% From 5/10/00 to 10/23/08 RSP favored and ret -.79% vs -33.62% for SPY. 10/23/08 to 4/16/09 SPY favored and returned 5.66% vs 1.50% RSP. 04/16/09 to 2/8/11 RSP return 76.11% vs 52.26% for SPY. (Excludes dividends) So...for the entire period calculated, buy & hold SPY +125%: buy & hold RSP +254%: switching into favored ETF when RS chart reversed, +337%.

Blog comments full of numbers are boring, I know. But an interesting, and flexible take on incorporating the various weighting methodologies in real asset allocation.

Jefferson@Morinda said...

Mea Culpa - I had previously calculated these numbers as of April 2010. When posting this comment I extended the calculation of the still favored holding of RSP through yesterday, but did not recalculate the total switching strategy performance to current. Those numbers are through April 2010.

I don't think it invalidates the point obviously.


Anonymous said...

Re: "indices" vs. "indexes"

"indices" is the original Latin plural. "indexes" is a modern (17th century) invention by the ignorant. Both are considered correct these days.

In other words, use "indices".

Anonymous said...

i would guess that 95% percent of people would be more comfortable/ familiar with indexes. however, the 5% of people who would prefer indices are the only 5% who will actually care about the distinction. both are acceptable - one is more traditionally correct.
Be proud - use language properly - if only to avoid the ire of grumpy grammar ninja's.
Disclosure - long on the 5% (reluctantly)

Hammer Player a.k.a Hoyazo said...

Both "indexes" and "indices" are real words, with different meanings. "Indexes" is appropriate in certain usages of the word -- for example, "That is the only ETF out there that indexes its portfolio in this way." Obviously you're not going to say "indices" in that sentence, so obviously the word "indexes" is part of the language today.

But as the plural of the noun "index", the right word should be "indices".

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