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

2024/25 super thresholds – key changes and implications

The ATO has released all the superannuation rates and thresholds that will apply from 1 July 2024. Here's what’s changing and what’s not, and some key considerations and opportunities in the lead up to 30 June and beyond.

Five months on from cancer diagnosis

Life has radically shifted with my brain cancer, and I don’t know if it will ever be the same again. After decades of writing and a dozen years with Firstlinks, I still want to contribute, but exactly how and when I do that is unclear.

Is Australia ready for its population growth over the next decade?

Australia will have 3.7 million more people in a decade's time, though the growth won't be evenly distributed. Over 85s will see the fastest growth, while the number of younger people will barely rise. 

Welcome to Firstlinks Edition 552 with weekend update

Being rich is having a high-paying job and accumulating fancy houses and cars, while being wealthy is owning assets that provide passive income, as well as freedom and flexibility. Knowing the difference can reframe your life.

  • 21 March 2024

Why LICs may be close to bottoming

Investor disgust, consolidation, de-listings, price discounts, activist investors entering - it’s what typically happens at business cycle troughs, and it’s happening to LICs now. That may present a potential opportunity.

The public servants demanding $3m super tax exemption

The $3 million super tax will capture retired, and soon to retire, public servants and politicians who are members of defined benefit superannuation schemes. Lobbying efforts for exemptions to the tax are intensifying.

Latest Updates

Retirement

Uncomfortable truths: The real cost of living in retirement

How useful are the retirement savings and spending targets put out by various groups such as ASFA? Not very, and it's reducing the ability of ordinary retirees to fully understand their retirement income options.

Shares

On the virtue of owning wonderful businesses like CBA

The US market has pummelled Australia's over the past 16 years and for good reason: it has some incredible businesses. Australia does too, but if you want to enjoy US-type returns, you need to know where to look.

Investment strategies

Why bank hybrids are being priced at a premium

As long as the banks have no desire to pay up for term deposit funding - which looks likely for a while yet - investors will continue to pay a premium for the higher yielding, but riskier hybrid instrument.

Investment strategies

The Magnificent Seven's dominance poses ever-growing risks

The rise of the Magnificent Seven and their large weighting in US indices has led to debate about concentration risk in markets. Whatever your view, the crowding into these stocks poses several challenges for global investors.

Strategy

Wealth is more than a number

Money can bolster our joy in real ways. However, if we relentlessly chase wealth at the expense of other facets of well-being, history and science both teach us that it will lead to a hollowing out of life.

The copper bull market may have years to run

The copper market is barrelling towards a significant deficit and price surge over the next few decades that investors should not discount when looking at the potential for artificial intelligence and renewable energy.

Property

Global REITs are on sale

Global REITs have been out of favour for some time. While office remains a concern, the rest of the sector is in good shape and offers compelling value, with many REITs trading below underlying asset replacement costs.

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.