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Which Is the Smartest Smart Beta: Equal or Fundamental Weighting?

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Alternative indexing proponents generally agree that market-cap weighting is dumb beta, but they differ as to whether fundamentally weighted or equally weighted indexing is smarter beta.

Research Affiliates, which pioneered fundamental indexing, makes the case in its current newsletter as to why the competing equal-weight approach is suboptimal despite its merits.

Indeed, authors Max Moroz and Engin Kose concede equal weighting’s many virtues. The alternative indexing approach is superior to traditional cap weighting, easy to understand and easy to explain, they say.

By giving equal weight to, say, the 100 largest stocks in a given universe, an equally weighted portfolio avoids the performance drag of cap-weighted’s preference for popular stocks and will also capture the return advantage of smaller stocks. 

But this story overlooks inferior selection and high implementation costs, the Research Affiliates authors argue.

Indeed, many professional investors who think of equal-weight indexing as avant garde may be surprised to learn that the  first very index fund was in fact equally weighted.

Moroz and Kose say that Wells Fargo index fund, initiated in 1970, was quickly scrapped because of the effort and cost its implementation entailed.

In those days when brokerage commissions were fixed (thus ensuring a high cost for a large portfolio that included some illiquid stocks) and when computers were only just emerging (thus ensuring tremendous effort in rebalancing), it was quickly grasped that market-cap weighting was far more practical as it is a virtual buy and hold strategy.

It thus took some four decades to revive equal weighting, which under today’s low-commission and computerized world, handily outperforms market-cap indexing “without a material increase in risk,” the authors say.

So why bother with a more complicated fundamental indexing approach? Because the strategy offers superior returns and lower costs, Moroz and Kose argue.

Both equally weighted and fundamentally weighted portfolios trump cap weighting by breaking the link with price that serves as a drag on cap-weighted portfolios.

“Stocks that are temporarily overpriced automatically receive a higher weight in the cap-weighted benchmark; conversely, stocks that are temporarily underpriced are given a lower weight,” the authors write.

That’s good so far, but the trouble for equal-weighted indexing starts with the strategy’s ignoring not just price but size.

By making disproportionate bets of smaller and thus less liquid stocks, equal-weighted portfolios add to implementation cost while only indirectly capturing “the noise in prices,” therefore generating performance less effectively.

In contrast, because fundamentally weighted indexes are selecting stocks on the basis of fundamental metrics, rather than just market capitalization, they are less likely to be overpriced, the authors say.

Indeed, in simulation covering eight countries over 28 years that compared the three indexing strategies, the Research Affiliates duo found that “the annualized returns of both smart beta strategies exceed those of the cap-weighted benchmark in almost every case, and the fundamentally weighted index consistently outperformed the equally weighted one.”

Fundamental indexing’s advantage over equal weighting reached as high as 280 basis points in the Australian market over the period under simulated study (1985-2013).

Addressing the claim that equal-weighing offers greater diversification, Moroz and Kose argue that diversification is not a goal but a means to achieving reduced risk, and they show that both strategies have roughly equal volatility.

“Most of the benefits of diversification can be achieved with a relatively small number of stocks; incrementally reducing concentration results only in marginal improvements,” they write.

While the fundamental strategy has outperformed equal weighting, the authors explain that the latter is inherently a higher-cost strategy since most of the cost of indexing stems from rebalancing, a factor that disadvantages equal-weighting in comparison to both fundamental and market-cap weighting.

That is because the equal weight index will more frequently need to replace less liquid stocks rather than merely trade back to a target weight.

What’s more, the net costs of rebalancing rise at high asset levels for equal-weight portfolios (with higher turnover and less liquid stocks) than fundamentally weighted indexes, the authors add. 

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