Investors are pouring money into index funds. According to the Wall Street Journal, index funds received a record $400 billion-plus in new assets in 2016. Almost all index funds simply own stocks in proportion to their size. Is there a better way?
Investing in a market capitalization-based index is perfectly reasonable, but it means that a small number of stocks with the highest market capitalization comprise the bulk of the popular indices. For example, the ten largest companies held in the S&P 500 make up nearly 20 percent of the total value of the index. Market cap weighted indices tend to be highly concentrated in a few large companies. As a result, a market cap weighted index exposes investors to significant individual company risk.
There is another way. An equally weighted index can provide investors with much more diversified stock market exposure. As its name implies, an equally weighted index simply applies equal weightings to each company included in the index. For example, each company held in the S&P 500 would be assigned a weight of two-tenths of a percent. This clearly reduces single stock risks, and is a sound way to build a core stock market exposure. While the cap weighted index ensures you will earn a rate of return equal to the average investor, the equally weighted index ensures you will earn a rate of return equal to the average stock.
Depending upon the reference index used and the time periods examined, an equally weighted portfolio of U.S. large cap stocks has outperformed its market capitalization counterpart by two percent per year. Similar results have been observed in international markets as well. The MSCI EAFE Equal Weighted Index and the MSCI Emerging Markets Equal Weighted Index have produced greater performance and higher Sharpe ratios than their cap weighted benchmarks over the past 10 years.
This past outperformance is no guarantee of future returns, and investors should be skeptical of buying into strategies that have performed well historically, as those results are often not repeated. It is important, therefore, to understand why this historical outperformance occurred, and whether similar results can be achieved going forward. We believe that there are good reasons to believe equally weighted indices will continue to outperform in the future.