Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 508

Why equal weighting resolves Australian index skews

An equal weighting investment strategy is different from traditional market capitalisation approaches. Equal weighting, as the names suggests, treats all the companies the same, equally weighting them so big swings in one company can’t skew the index.

By way of contrast, in market capitalisation indexes, companies which make up the index are included in amounts that correlate to their total market capitalisation. The bigger the company, the bigger the proportion it represents of the index.

Most of the equity indexes quoted in the media are market capitalisation indexes, for example, the S&P/ASX 200 Index is a market capitalisation index. Moreover, the S&P/ASX 200 index is one of the most concentrated sharemarket indexes in the world. The largest 10 companies represent over 45% of the index.

This means that big-company constituents can shift the index more than little ones. This is great when those big companies are on the way up, but not so great when they are on the way down or have limited potential for growth.

Equal weighting offers an alternative method to investors and they have historically outperformed their market capitalisation counterparts over the long term. The following chart demonstrates this, though we always caution, past performance cannot be relied upon for future performance.

This chart shows the performance of Australia’s standard equal weighted index, the MVIS Australia Equal Weight Index against Australia’s standard market capitalisation weighted index, the S&P/ASX 200 Index (S&P/ASX 200).

In various studies it has been shown that equal weighting performs well because of the following reasons:

  1. Higher exposure to smaller stocks rather than larger stocks
  2. Higher exposure to so-called ‘value stocks’ meaning those stocks with a high book-to-market ratio, and
  3. Better market timing as equal weighting extracts more returns when markets are rising and loses less when markets are falling.

1. Higher exposure to smaller stocks

An equal weight approach provides greater diversification by reducing concentration risk both at an individual stock level and a sector level.

A mathematical analysis demonstrated that equal weighting outperformed because of its greater exposure to smaller stocks, which outperform larger stocks. The word ‘smaller’ was used in the analysis with its precise meaning as a relative term. There was no suggestion that the stocks referred to in the paper were small aps. Rather, these are stocks smaller than those mega-caps who, because of their size, dominate market capitalisation indices. 

The mathematical analysis in Why Equal Weighting Outperforms: The Mathematical Explanation showed that the returns from the larger caps are more narrowly distributed than their ‘smaller’ peers so never deliver the very high returns that will be generated by some of the smaller stocks (the paper uses the top 12 to represent the ‘larger’ stocks). You can see this in the figure below, taken from the paper.

We recently highlighted how this is relevant during periods of market recoveries in The road to recovery (revisited): Further analysis of equal weight performance after market declines.

2. Higher exposure to value stocks

Rebalancing an equal-weight index also injects a mild value tilt into the portfolio. In order to maintain its desired weights, the strategy will sell shares that have appreciated relative to their target weight and use the proceeds to buy those that have declined since the previous rebalance.

By assigning the same weight to each constituent, the equal weight index is simply tilting toward stocks with smaller market capitalisations and lower valuations, which have historically outperformed their larger and more expensive counterparts. Mechanically shifting assets away from companies that have become more expensive and toward those that are now cheaper can be an advantage when the market’s valuation reaches extremes (either too expensive or too cheap).

According to research from Plyakha, Uppal and Vilkov[1] the higher systematic return of the equal-weighted portfolio arises from its higher exposure to the market, size, and value factors.

3. Better market timing

Research by Lajbcygier, Chen and Dempsey (2015)[2] analysing US data over a period of nearly 50 years found that equal-weighted indexing had a statistically significant positive bi coefficient, meaning that it is able to systematically ‘time’ the market by outperforming in down markets. 

In Australia, the universe of companies is too small and too concentrated and there is a lack of variability over time. A concentrated market limits stock diversification and means investors potentially overlook the stronger opportunities among smaller companies.

Equal weighting offers investors a strategy that has historically outperformed market-capitalisation indexes over the long-term. The choice to equally weight also helps risk management and better diversify, avoiding overexposure to any single name.

 

Cameron McCormack is a Portfolio Manager at VanEck Investments Limited, a sponsor of Firstlinks. This is general information only and does not take into account any person’s financial objectives, situation or needs. Any views expressed are opinions of the author at the time of writing and is not a recommendation to act.

For more articles and papers from VanEck, click here.

 

[1] Why Does and Equal-Weighted Portfolio Outperform Value- and Price Weighted Portfolios?, Plyakha, Raman Uppal and Grigory Vilkov January 31 2012

[2] Lajbcygier, Paul & Jeremy Sojka, 2015, “The viability of alternative indexation when including all costs” CSIRO Monash Superannuation Research Cluster, Working paper series

 

RELATED ARTICLES

Are markets broken?

Three ways index investing masks extra risk

Why market forecasts matter to long-term investors

banner

Most viewed in recent weeks

Meg on SMSFs: Clearing up confusion on the $3 million super tax

There seems to be more confusion than clarity about the mechanics of how the new $3 million super tax is supposed to work. Here is an attempt to answer some of the questions from my previous work on the issue. 

Welcome to Firstlinks Edition 566 with weekend update

Here are 10 rules for staying happy and sharp as we age, including socialise a lot, never retire, learn a demanding skill, practice gratitude, play video games (specific ones), and be sure to reminisce.

  • 27 June 2024

Australian housing is twice as expensive as the US

A new report suggests Australian housing is twice as expensive as that of the US and UK on a price-to-income basis. It also reveals that it’s cheaper to live in New York than most of our capital cities.

The catalyst for a LICs rebound

The discounts on listed investment vehicles are at historically wide levels. There are lots of reasons given, including size and liquidity, yet there's a better explanation for the discounts, and why a rebound may be near.

How not to run out of money in retirement

The life expectancy tables used throughout the financial advice and retirement industry have issues and you need to prepare for the possibility of living a lot longer than you might have thought. Plan accordingly.

The iron law of building wealth

The best way to lose money in markets is to chase the latest stock fad. Conversely, the best way to build wealth is by pursuing a timeless investment strategy that won’t be swayed by short-term market gyrations.

Latest Updates

Financial planning

Our finances should enable and not dictate our lives

Most people would prefer to have more money than less of it. But at what point do the trappings of wealth and success start to outweigh the benefits of striving for more?

Economy

This vital yet "forgotten" indicator of inflation holds good news

Financial commentators seem to have forgotten the leading cause of inflation: growth in the supply of money. Warren Bird explains the link and explores where it suggests inflation is headed.

Shares

Emerging market equities are ripe with opportunity

Emerging markets offer compelling value compared to history and the stretched valuations of developed market equities. Investors can benefit from three big tailwinds, but only if they are selective.

Taxation

Tomorrow's taxpayers pay for today's policy mistakes

Less affordable housing isn't the only thing set to weigh on Australia's younger generations. If new solutions for pension deficits and the use of resource revenue aren't found quickly, tomorrow's taxpayer will foot the bill.

How would a switch to nuclear affect electricity prices?

The Coalition's plan to build seven nuclear power stations in 15 years faces scrutiny due to high costs and slow construction. And it is unlikely the investment would yield cheaper energy for Australian households and industry.

Strategy

Reader feedback from our 2024 survey

Articles that are easy to understand, quick to read, and credible; being able to engage via the comments section; and keeping Firstlinks free and independent are just some of the features valued by our readers.

Strategy

Have your say on Firstlinks and the topics we cover

We’d love to hear your thoughts on Firstlinks and how we can make it better for you. If you’d like to help us out in a just a couple of minutes, please take our short survey.

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.