The Impact of Cycles on Equal-Weighted and Market-Weighted Portfolios

It is fairly common knowledge in financial circles that equal-weighted portfolios tend to outperform portfolios weighted by market capitalization, whether the portfolio is composed of U.S. stocks, foreign stocks, or emerging market stocks.  As Tobias Carlisle has written (citing research by Joel Greenblatt), equal-weighted portfolios tend to outperform market-cap weighted portfolios because they avoid the main flaws of market-weighted portfolios, which are generally buying more of the same stocks as they become ever more expensive (thus leaving less exposure to cheaper stocks), and having greater exposure to hot sectors during bubble-type periods, such as the tech boom of the 1990s.  Furthermore, equal-weighted portfolios tend to have far more exposure to smaller companies which, as they grow, are more likely to outperform larger companies, which may have more limited growth opportunities.

It may surprise some people, however, just how much the difference in performance has been.  Since January of 1971 through April, the equal-weighted version of the Wilshire 5000 Index has returned almost 17% annually, versus roughly 10.5% for the market-cap weighted Wilshire 5000:


As telling as these results are, they don’t tell the whole story, simply because during this period there were many cycles of booms and busts, both for the market as a whole, and for certain sectors in particular.  While we know that equal-weight won out over the time period shown, we can add some context to the discussion by comparing three-year rolling returns of the two portfolios:


From the chart, it is easy to see that equal-weight started off at a pretty big disadvantage after the market crash of 1973-74, only to surge ahead in the ensuing recovery.  Similarly, during the early 1990s, more exposure to small capitalization stocks, – of which smaller financial institutions make a fair amount, – dragged down equal-weight’s relative performance during the Savings & Loan Crisis, which punished small banks and financials.  More recently, the tech bubble, – during which the technology sector peaked at more than one-third of the S&P 500’s composition, – and the financial crisis and recession of 2007-2009 were strong periods for market-cap weighted portfolios.

However, this analysis comes with a caveat.  As Sam Lee has pointed out, the Wilshire 5000 equal-weight index is full of uninvestable micro-cap stocks, so it may not be the best tool for showing the equal-weight effect.  In Sam’s opinion, the “High 30 Portfolio,” which is a construct of Professor Ken French’s (data available on his site), is a much better proxy for the market as a whole, and Professor French has conveniently constructed both an equal-weight and market-weighted version of this portfolio.  As one can see from the graphs below, the results of comparing the “High 30” equal-weight and market-weighted portfolios are similar to the Wilshire 5000 results shown above, but they are obviously less pronounced, and probably more realistic:

Total Return:


Relative Returns:


So, that being said, I will be using the “High 30” portfolios instead of the Wilshire 5000 portfolios in the remainder of this analysis.

To explore further the impact of cycles on equal-weighted performance vs market cap weighted performance, it is helpful to decompose the indices, and attempt to look at the results under a microscope, as it were, by comparing equal-weighted and capitalization-weighted portfolios by sector.  To do so, I utilized the “Ten Industry” portfolios which are also available on Professor Ken French’s site.  Unfortunately, Professor French lumps his “Ten Industry” portfolios together into somewhat awkward portfolios, which only roughly correspond with the GICS sector methodology.  Happily, Meb Faber has provided us with a key to understanding the components to Professor French’s ten portfolios:

Professor French provides both market-cap weighted and equal-weighted versions of his ten industry portfolios, and comparisons yield fascinating results.  For example, equal-weighted portfolios actually underperformed in the energy, non-durable, and “shops” sectors:


The results in the “non-durables” sector (which roughly corresponds with what are normally referred to as “consumer staples”) should not be that surprising.  The sector tends to be dominated by many large companies such as Altria, Colgate-Palmolive, and the like, which have grown in market share after much consolidation.  Furthermore, valuations for consumer staples tend to be more uniform and stable than other industries, thus negating one of the key advantages of an equal-weight portfolio.  Therefore, the impact of newer, smaller companies into the space has been limited, while concentration at the top has been a net benefit, likely the result of the wide moats enjoyed by the incumbents in this space.  It is also a main reason why I have written favorably about consumer staples in general, and tobacco in particular; they seem to be less prone to disruption than other industries.

The energy sector is interesting because its bull and bear cycles are generally tied to one thing, which is the price of oil.  Since 1971, oil has been in several extended bull and bear markets, largely tied to moves in the dollar and geopolitical events such as those in the Middle East.  When oil is rising in price, it is natural for new players to enter the market in hopes of cashing in on the new bull market.  However, oil is a capital intensive industry, and so when cycles turn, newer entrants are usually weaker and more highly leveraged, and so they are usually the first to go bust.  That is exactly what has happened over the last few years.  This point can be illustrated by showing changes in the price of oil with relative changes in the performance of the two energy portfolios.  When energy is strong, the equal-weighted portfolio tilted toward newer, smaller players outperforms, but when oil goes south, there is a flight to quality like Exxon Mobil and Chevron:


It is also instructive to study the telecommunications sector, which, like energy, is somewhat unique.  We can see from the table above that the equal-weighted telecommunications portfolio outperformed the market-cap portfolio by almost three percentage points annually, despite suffering a drawdown of almost 90%.  Someone looking at just those statistics could not be blamed for wondering why any telecom investor would go with the market-weighted portfolio.  Yet what is missing from this analysis is an accounting of the bubble in telecommunications stocks that occurred simultaneously with the tech bubble of the 1990s, and that in many ways dwarfed its more famous contemporary.  In many ways, the telecom industry is still feeling the effects of the bubble, and this can be seen by observing that since 2000, which is about the time the bubble peaked, the market cap portfolio has handily outperformed equal-weight, as the larger and more robust companies survived the bust and moved on, while the smaller telcoms that composed the equal-weighted portfolio languished:


The lesson here for investors is that in the aggregate, and over periods long enough to smooth out “intra-cyclical cycles,” if you will, equal-weighted portfolios can, and should, deliver superior results for the reasons mentioned above.  However, in the shorter-term, particularly in more concentrated segments of the equity market, – especially those like energy and telecommunications with historical tendencies to periods of over-investment, – equal-weighted portfolios can suffer severe periods of underperformance after the bubble bursts, and investor results will be inordinately impacted by the timing of his or her investment.

Addendum:  To demonstrate further the impact of cycles on certain sectors, I charted the relative performance of the non-durable, telecom, and energy sector equal-weighted portfolios less the market-cap weighted “High 30” portfolio (which represents the market), and the relative performance of the cap-weighted sector portfolios less the “High 30.”  My logic here is that in “supercycles,” or “bubbles,” in a given sector, the equal-weighted portfolio should show extreme outperformance versus not only the market in general, but also against the cap-weighted sector portfolio.  One can see from the telecom and energy charts that that is exactly what happened during periods of over-investment in those sectors, with extreme underperformance once the bubbles burst.  Non-durables, on the other hand, showed much more muted relative performance:


Disclosure:  The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index.

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