The Inflation Advantage of Equal-Weight

I have written favorably several times before about the advantages of equal-weighted portfolios, and it is worth reminding readers that going back to 1990, the S&P 500 Equal-Weight index has not suffered a single negative 120-month return, which stands in stark contrast to the capitalization-weighted parent index, which experienced several negative 120-month periods around the time of the financial crisis:

There are various explanations for this superior and more consistent performance, some of which we have touched on in articles before:  a greater exposure to big winners, reduced concentration in sectors and large companies, and, as a result of all of these, typically shorter and shallower drawdowns.

There is another apparent advantage to the equal-weight portfolio, and that is reduced sensitivity to the kind of cost-push inflation caused by higher commodity prices.  Since 1990, about one-fifth of the S&P 500 Equal Weighted index’s superior 60-month returns can be explained by positive increases in commodity prices:

There are a good explanations for this phenomenon.  For one, the equal-weighted index has exhibited far more consistency in terms of its sector exposure over time (via SPDJ):

We have discussed previously how equal-weighted energy exposure benefits greatly during oil bull markets.  However, the advantages of equal-weighting in these conditions do not stop with energy.  Within sectors like industrials and materials, the equal-weighted portfolios give investors more exposure to sub-industries like railroads in the former, and miners in the latter, that benefit from higher commodity costs:

Unlike the equal-weighted S&P 500, the capitalization-weighted S&P 500 index has been prone to over-representation in certain sectors, namely technology in the late 1990s, and financial and energy stocks circa 2007-2008.  This is important for today’s S&P 500 index investors because technology has once again gained supremacy in the index, composing more than one-fourth of its value.  This poses a bit of an inflation risk to indexers as, historically, technology shares have been the most negatively affected by commodity price increases (via SPDJ):

As I have warned before, indexing alone does not provide sufficient diversification, and investors would do well to look at ways to balance out the exposures their indexing strategies imply as it seems unrealistic to assume that cost-push inflation will continue to be as benign as it has been during the current bull market.