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

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

May 18, 2015 Research Insights, $SPY, $rsp
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(Last Updated On: January 18, 2017)

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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Definitions of common statistics used in our analysis are available here (towards the bottom)




About the Author

Wesley R. Gray, Ph.D.

After serving as a Captain in the United States Marine Corps, Dr. Gray earned a PhD, and worked as a finance professor at Drexel University. Dr. Gray’s interest in bridging the research gap between academia and industry led him to found Alpha Architect, an asset management that delivers affordable active exposures for tax-sensitive investors. Dr. Gray has published four books and a number of academic articles. Wes is a regular contributor to multiple industry outlets, to include the following: Wall Street Journal, Forbes, ETF.com, and the CFA Institute. 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.


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  • dph

    Have you guys studied if small caps and value stocks fall faster or even ultimately lower on an absolute basis when the market is in a reversion (maybe below the 50 or 200 MA or some metric)?

  • Styv

    Thank you for the additional info and links.

    In the Plyakha-Uppal-Vilkov article much of the EW alpha is attributed to rebalancing (42% of the total excess mean return by EW over VW, 96% of the total excess mean return by EW over PW).
    Plyakha-Uppal-Vilkov seem to think monthly rebalancing is critical and suggest the outperformance of EW portfolios cannot be replicated by a passive portfolio overweighting small cap (but I could not find mention of a passive portfolio overweighting both small cap and value).
    What are your thoughts on the ability to replicate EW portfolios (rebalanced monthly) with passive portfolios overweighting small cap and value? Are the correlations of historical data for EW portfolios and combined passive small cap and value portfolios just data mining or am I overstating Plyakha-Uppal-Vilkov’s view on the need for rebalancing to achieve outperformance?

  • Jack Vogel, PhD

    There is an ETF (RSP) which follows the S&P 500 EW — this would probably be the easiest way to access the EW returns:

    http://guggenheiminvestments.com/products/etf/details?productid=92

  • Jack Vogel, PhD

    Not specifically — the R2K (small/mid cap firms) has similar drawdowns in 2007-2009 compared to the S&P 500 (large cap firms).

  • Styv

    Some, like Antonacci, seem to recommend constructing a passive
    portfolio that correlates to equal weight or other smart beta portfolios and saving the added “smart beta” expense of funds like RSP.
    Plyakha-Uppal-Vilkov may be suggesting this is wrong.

  • Jack Vogel, PhD

    One always has to weigh the costs (expense ratio) of the fund to the benefits (any alpha or additional return which equal-weighting gives you). In some cases, the benefits outweigh the costs.