What Drives the S&P 500 Equal-Weight Return Premium?

What Drives the S&P 500 Equal-Weight Return Premium?

May 18, 2015 $rsp, $SPY, Research Insights

Last updated on January 18th, 2017 at 02:43 pm

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A recent academic paperEqual or Value Weighting? Implications for Asset-Pricing Tests, highlights two methods of weighting: Equal-weight and Value weight.

As the paper states:

With monthly rebalancing, an equal-weighted portfolio outperforms a value-weighted portfolio in terms of total mean return, four-factor alpha, and Sharpe ratio…The higher systematic return of the equal-weighted portfolio relative to the value- and price-weighted portfolios arises from its relatively higher exposure to the value, size, and market factors.

This paper summarizes the key findings from an old post we did almost a year and half ago:

The Value-weight VS. Equal-weight Update

We updated the EW vs. VW horse race with latest data: From 1/1/1963 to 2/28/2015, SP500 Equal-weight outperforms SP500 Value-weight by 2.25%, annually.  The strategy delivers higher Sharpe and Sortino ratios.

SP500 EW and VW
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Many people attribute the EW premium to the “size” factor. What does that mean? As we know, the SP500 EW includes the exact same companies as the SP500 VW, however, the EW version gives equal-weight to each company, regardless of size. In other words, Apple Inc (Market Cap: ~755B) has the same weight as Diamond Offshore Drilling Inc (Market Cap: ~ 4.46B) in the EW index.

So size is definitely one reason why the EW index has likely outperformed the VW index, but size isn’t everything…

Factor analysis on SP 500 EW

Below we highlight the factor analysis for the S&P500 EW. A few observations:

  • A small size tilt (as measured by SMB).
  • A fairly large exposure to the “value factor” (HML), which suggests that the EW Index performance is driven not only by size, but also by value!
  • The EW index also a beta of ~1.1, giving it a little more market risk than the VW index.
SP500EW factor analysis
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Below we show the factor analysis of S&P500 VW. A few comments:

  • A beta of 1, which is intuitive.
  • A negative size factor (i.e., the value-weight index tilts large).
  • A flat value exposure.
SP500 VW factor analysis 1
SP500EW factor analysis The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Summary Findings

Casual market observers suggest that the EW index is driven by a small cap bias. This observation may a bit too casual.

The evidence suggests that much of the outperformance is likely driven by a heavy value exposure and a slightly higher beta.

Going forward, and assuming that the factor loadings stay the same, we can expect the S&P 500 EW index to outperform if small-caps earn a premium, value-stocks earn a premium, and the market continues to grind higher over the long-haul.

Good luck,

Wes


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About the Author

Wesley R. Gray, Ph.D.

After serving as a Captain in the United States Marine Corps, Dr. Gray received a PhD, and was a finance professor at Drexel University. Dr. Gray’s interest in entrepreneurship and behavioral finance led him to found Alpha Architect. Dr. Gray has published three books: EMBEDDED: A Marine Corps Adviser Inside the Iraqi Army, QUANTITATIVE VALUE: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors, and DIY FINANCIAL ADVISOR: A Simple Solution to Build and Protect Your Wealth. His numerous published works has been highlighted on CBNC, CNN, NPR, Motley Fool, WSJ Market Watch, CFA Institute, Institutional Investor, and CBS News. Dr. Gray earned an MBA and a PhD in finance from the University of Chicago and graduated magna cum laude with a BS from The Wharton School of the University of Pennsylvania.