Historically, institutional investors in developed markets, including Japan, Singapore and Hong Kong, have been primarily concerned about generating alpha against traditional market-capitalization-weighted indexes. However, the trend is shifting and investors are showing growing interest in “alternative weighting” methodologies such as equal weighting and fundamental weighting.
This is key for the region’s money managers and investors as equal weight indexes are expected to become widely used, particularly in investable products such as exchange traded funds (ETFs). The easy-to-understand structure means they can also be used by individual investors in both developed and emerging markets.
Another factor comes down to returns. There is a difference in the long-term performance of the market-cap-weighted (MC) and equal weight (EW) indexes. From a long-term perspective (approximately 10 years), it is clear that the equal weight index significantly outperformed the cap-weighted index in the US large cap market. This can be seen in be below example (figure 1).
It’s also a trend which can be seen across Asia. Compare the performance of the cap-weighted index and the equal weight index in the Russell Greater China Large Cap Index. This is a regional index comprising China, Taiwan and Hong Kong. The difference in the weight and the performance of the constituents in the cap-weighted index and the equal weight index are the main contributions to the outperformance of equal weight index over cap-weighted index.
Examining the construction and methodology of Russell Equal Weight Index, which is a Russell family of indexes, the followings may explain the outperformance:
(i) Russell Equal Weight Indexes first assigns equal weight to each sector. Consequently, when the heavier-weighted sectors in the cap-weighted index perform better than the lower-weighted sectors, cap-weighted index outperforms equal weight index. Conversely, when the heavier weighted sectors in the cap-weighted index perform worse than the lower-weighted sectors, equal weight index performs better.
(ii) Russell Equal Weight Indexes assigns equal weight to the constituent stocks within each sector after equal weight sectors. Consequently, when larger market cap securities outperform the smaller market cap securities, the cap-weighted index outperforms the equal weight index. Conversely, when the smaller market cap securities outperform the larger market cap securities, the equal weight index fares better.
(iii) The Russell Equal Weight Indexes are constructed from the same stock universe as the underlying cap-weighted index. At the quarterly re-weighting, each sector is re-weighted back to its target weights, and then constituents are assigned equal weight within sectors .
For money managers reviewing benchmarking options, it’s worth considering the role of volatility among sectors within any particular index. Compare the sector structure of the Russell Greater China Large Cap Index (cap-weighted) with the Russell Greater China Large Cap Equal Weight Index as of March 31, 2011. In the cap-weighted index there is a considerable variation in the weights of the sectors, while in the equal-weight index the weights of all sectors are almost the same. In the cap-weighted index, the financial services sector (35 percent) and technology sector (19 percent) have the greatest weights in Russell Greater China Large Cap Index. While the performance of the cap-weighted index is particularly sensitive to the performance of these dominating sectors, the performance of the equal weight index is impacted by each sector equally.
Relationships, as always, are a factor. The below table (figure 3) shows the relationship between sector weights and sector returns of Russell Greater China Large Cap Index and Russell Greater China Large Cap Equal Weight Index. A detailed look at each sector indicates that Financial Services and Technology sectors (the largest weighted sectors in the cap-weighted index), performed worse than the smaller weighted sectors - Energy and Consumer Discretionary sectors. This is one of the factors contributing to why equal weight index outperforms the cap-weighted index. It is worth noting that the Technology sector, the second largest weighted sector (with a weight of over 20%) had the lowest return among the 7 sectors , which could have been the performance detractor in the cap-weighted index.
As the weights between and within the sectors vary, the overall weights by country - or markets - also vary considerably from cap-weighted to equal weight index. China has approximately 15 percent more weight in the equal weight index than that in the cap-weighted index, hence Taiwan and Hong Kong have lower weights by approximately 10 percent and 4 percent respectively.
Cap-weighted indexes clearly provide broad market representation, with constituents’ weights being based on their market capitalization, which results in the largest securities having the largest weights in the index and the contribution of the smaller capitalization can be very small. While cap-weighted index remains to be the best proxy for benchmarking, there is a growing interest in alternative weighting methodology for passive investment products.
Equal -weight indexes display superior returns in the long-term when compared to traditional market-capitalization weight indexes. The Russell Greater China Large Cap Equal Weight Index, discussed in this paper, also consistently performs better than the Russell Greater China Large Cap Index (cap-weighted), regardless of the state of the market.
Noriyuki Oharazawa is Index Strategy Director for Russell Indexes