- In 2021, diversifying a portfolio has become more challenging due to declining bond yields and the need for potential replacements to fixed-income instruments.
- When it comes to equity allocations, the debate between market-cap and equal-weighted strategies continues, with no clear consensus on which is preferable.
- Historical data shows that small-cap stocks have outperformed large-cap stocks, but these returns may not be as impressive in recent years.
- During previous stock market crashes, both equal-weighted and market-cap weighted portfolios have experienced similar drawdowns, though there were instances where the equal-weighted portfolio had smaller drawdowns.
- Equal-weighted portfolios may offer higher returns over the long run but may not be accessible to large institutional investors due to liquidity requirements.
Introduction
Implementing a diversified and low-cost investment strategy can be challenging for investors. In 2021, with declining bond yields and the need for potential replacements for fixed-income instruments, the search for attractive risk-adjusted returns has become more difficult. While a simple equity and bond portfolio has historically been sufficient, investors now face the challenge of finding new asset classes to diversify their portfolios.
One area of debate within equity allocations is the weighting methodology to use. Market-cap and equal-weighted strategies are two common approaches, each with their own merits. Market-cap weighting follows the principle of investing in stocks based on their market capitalization, while equal-weighted portfolios allocate an equal amount of capital to each stock.
Historically, research has compared the performance of equal-weighted and market cap-weighted equity strategies, but there is no clear consensus on which approach is superior. The debate becomes even more complex when considering the performance during stock market crashes.
Performance Aspects
Historical data from the Kenneth R. French Data Library shows that small-cap stocks have outperformed large-cap stocks, especially before 1981. However, since then, small-cap performance has been lackluster. It is important to consider that these are back-tested returns and do not include transaction costs. To make the returns more realistic, it is practical to exclude the smallest, least liquid stocks from the analysis.
Stock Market Crashes: Equal vs. Market Cap-Weighted
An analysis of stock market crashes between 1926 and 2021 reveals that equal-weighted portfolios and market-cap weighted portfolios had similar drawdowns on average. However, there were instances where the equal-weighted portfolio had smaller drawdowns than its market-cap weighted counterpart. These differences occurred in 1932, 1933, 1942, 1978, and 2002.
While equal-weighted portfolios may offer slightly higher volatility due to the inherent volatility of smaller companies, the risk is comparable to market-cap weighted portfolios.
Further Thoughts
Two additional factors to consider when evaluating equal vs. market-cap weighted indices are exposure to size and value factors and liquidity requirements for institutional investors.
Cap-weighted indices have negative exposure to the size and value factors and positive exposure to the momentum factor. In the event of a tech bubble implosion like in 2000, these exposures could significantly impact the performance of a cap-weighted portfolio.
Large institutional investors often have no choice but to adopt market-cap weighted strategies due to their liquidity requirements. Investing in small caps or emerging markets can be more expensive and less feasible in terms of trading large-cap US stocks. This limitation may prevent these investors from accessing the potentially higher returns offered by equal-weighted portfolios.
It is important to note that while historical data and analysis provide insights, they should not be seen as investment advice. Individual investors should consider their own goals, risk tolerance, and financial circumstances before making investment decisions.
