Question: Can you review the research on market weighting vs. equal weighting vs. fundamental weighting? What might be the long-term advantage in return for one method vs. another (or, to put it another way, how much can I expect to lose if I chose the wrong method)?
Answer: My primary reason for preferring the use of alternative market indexes is to minimize the risk of extreme concentration in a relatively small number of large stocks, rather than because I’m confident of superior long-run returns. I have long been dubious about simple strategies that appear to beat the market averages in hypothetical back-tested studies. Most ignore the costs, including commissions, bid-ask spreads, and market impact, which were much higher in the past than today, and might have explained some real anomalies which existed only because there was no way to exploit them after all costs were considered. Many other anomalies were just random events.
One of my favorite quotes on academic studies purporting to show ways of beating the market is from Richard Roll, included in Burton Malkiel’s brilliant book, A Random Walk Down Wall Street. “I have personally tried to invest money, my client’s money and my own, in every single anomaly and predictive device that academics have dreamed up … And I have yet to make a nickel on any of these supposed market inefficiencies.”
So you need to understand that my goal in using alternative weighting is to maximize diversification and not to beat the market averages. Were you to ask a traditional index investor why they expected to make more money in the index fund than by purchasing individual stocks, he’d likely answer that he wasn’t indexing because he thought it would improve returns but because he thought it would reduce risk. I prefer the equally weighted S&P 500 Index fund to a traditional S&P 500 Index fund because I don’t want 35% of my money invested in just 25 stocks, many in the same sector, as the latter does.
Still, I’m intrigued by the “noisy market hypothesis.” It is certainly true that we lack perfect knowledge of the future and are uncertain about future cash flows from investments, that virtually every stock is either overpriced or underpriced based on the present value of those future cash flows (just as virtually nobody dies on the same day the mortality tables predict, even if he or she is accurate on average), and that the nature of a market weighted index is that it automatically overinvests in overpriced stocks and underinvests in underpriced stocks. Any index that randomizes the effect of mispricing should do better than one that automatically includes every one. Equal weighting and fundamental weighting both do that.
Now, as far as specific research: For equal weighting, my own initiation was a study by Leuthold Research that went back to the creation of the S&P index (initially 425 stocks, now 500) that was published more than 10 years ago. As far as I know, it isn’t available on the Internet, but it showed that, in the 43 years from 1958 to 2000, the equal-weight version beat the market-weight version by 2.7% per year before expenses (11.3% vs 8.6%). Given the higher annual turnover of the former (around 25%), and the higher commissions and spreads back then, around half a percent per year would likely have been lost to trading costs, leaving 2.2% per year as the potential advantage. But this was all hypothetical, until 2003, when Standard & Poors introduced the EWI as an index, and Rydex created RSP, the Rydex (now Guggenheim) S&P 500 Equal Weight ETF. It just celebrated its 10th anniversary a couple of months ago, and unlike all those other theories that didn’t pan out, this one did: RSP beat SPY (the SPDR S&P 500 ETF, which uses traditional market weighting) by a 10.3% to 7.7% margin, or 2.6% per year. Remember that is after all expenses, including management fees. So it actually has done better than the earlier study. And really did. And I had many clients invested in it, so unlike Richard Roll I did actually make a nickel for my clients. And I have no idea if it was luck or an advantage that will soon be arbitraged away or a permanent feature of the market.
There was a recent paper celebrating the 10-year anniversary of the EWI, which you can download for free here, entitled “10 Years Later: Where In The World Is Equal Weight Indexing Now?”
As for fundamental weighting, Robert Arnott has done research that can be found all over the Internet and has basically argued that fundamental weighting works for the same reason equal weighting works, because it randomizes pricing errors instead of systematically including them, as market weighting does. The oldest fundamental ETF is PRF, the PowerShares FTSE RAFI US 1000 ETF. It started trading on December 20, 2005, and, as of this writing in mid-August of 2013, is up 75.6%, compared to RSP, which is up 74.1%. (In case you’re wondering, SPY is up only 56.7% during that time.) Not only has performance been virtually identical overall between PRF and RSP, but the correlation of movements has been 98%, which is in line with Arnott’s claim that they are basically just variations on the same theme.
Arnott recently issued that I consider one of the most amusing papers I’ve ever read, which shows that you’d beat the market with all these alternative indexes but also beat the market if you weighted based on the OPPOSITE of these alternatives. So weighting stocks by volatility beats the average, but so does weighting stocks inversely by volatility. Weighting stocks by earnings beats the average, but so does weighting stocks inversely by earnings. And the famous monkeys throwing darts at the Wall Street Journal don’t just do as well as the market, they beat it! The paper can be found here and is entitled, “The Surprising ‘Alpha’ from Malkiel’s Monkey and Upside-Down Strategies.”
That’s enough to get started. Once again, my reason for preferring these alternatives is that I don’t like to place big bets on individuals stocks, industries, or even countries, and this argument remains even if it turns out that the success to date of these alternatives in earning superior returns fails to continue going forward. Earning an extra 2% per year would be a wonderful bonus but, in planning for my clients’ futures, I don’t count on it.