Diversify, reduce fees, avoid active trading and keep it simple.
Most investors would be well served by following the above framework. But although easy to recommend, this rubric is rather difficult to implement.
For example, how does an investor diversify in 2021? Over the past 40 years, a simple portfolio of stocks and bonds has done a fabulous job of generating attractive risk-adjusted returns. Not much was needed beyond these two asset classes. But with falling bond yields, fixed income instruments have lost much of their shine. There are potential substitutes – hedge fund strategies, for example – but these can be complex and expensive.
Indeed, other even simpler questions about asset allocation also lack easy answers. Consider the base equity allocation. According to the framework, diversification, both between and within asset classes, is essential. For US-based investors, this means exposure to international and emerging markets. But what distribution formula should they apply? Market capitalization or equally weighted? Maybe factorial?
The same question applies to US equity allocations. How should they be weighted? Larger investors often have little choice. Given their liquidity needs, they should pursue market capitalization weighting. However, smaller, more nimble investors can allocate more to less liquid stocks.
Researchers have long compared the performance of equally-weighted and market-cap-weighted equity strategies, but no clear consensus has emerged on which is better. In the last two stock market crashes, during the Global Financial Crisis (GFC) in the late 2000s and the COVID-19 pandemic last year, a market-cap-weighted portfolio outperformed the US stock market.
But two data points are hardly statistically significant. What about previous slowdowns? How have equal and market cap weightings of US stocks fared in previous stock market crashes?
A comparison of the portfolios of US stock market deciles argues in favor of an equal weighting. According to data from the Kenneth R. French Data Library, the smallest 10% of stocks did much better than the largest 10%. Since this is the size factor, those familiar with factor investing would hardly find this result surprising.
CAGR by market capitalization decile in the US stock market, 1926 to 2021
Although small-cap performance has been attractive over the 90 years since 1926, excess returns were mostly generated before 1981, when Rolf W. Banz published his seminal article on small cap stocks. Since then, the performance of small caps has been rather lackluster, so there is much less enthusiasm for the size factor among investors today than in the past.
Further, these historical returns are retrospective rather than realized. And the smallest 10% of stocks have tiny market caps and aren’t liquid enough for most investors. Theoretical size factor returns would be significantly lower if transaction costs were included.
Since we focus on practical financial research, we will exclude the bottom 20% of the smallest stocks from our analysis. This decreases the returns of an equal-weighted strategy, but also makes them more realistic.
US stock market CAGR, 1926 to 2021
Market Crashes: Equal or Market Cap-Weighted
Of the 18 worst stock market crashes between 1926 and 2021, some, like the 1987 plunge, were short-lived, while others were long bear markets that lasted for more than a year. These market declines have been driven by various causes, ranging from wars and geopolitical conflicts to economic recessions, bubbles and a pandemic.
Broadly speaking, the declines of our new equally-weighted portfolio and its market-cap-weighted counterpart were similar. However, in five cases – in 1932, 1933, 1942, 1978 and 2002 – they diverged by 10% or more. In each case, the equally weighted portfolio showed lesser declines.
Market crashes: market-cap-weighted portfolios and equivalents
Based on the chart above, investors might assume that equally weighted portfolios fared better during stock market declines in general, but the mean and median over the 90-year period were almost identical.
Although the risk is similar when comparing downsides, smaller companies tend to be a bit more volatile than their larger counterparts. Thus, the equally-weighted portfolio had slightly higher volatility, 16% versus 15% for the market-cap-weighted portfolio.
Stock market crashes, 1932 to 2021: equal and market-cap-weighted portfolios
Beyond risk considerations, two other factors should be considered when evaluating equal versus market-cap-weighted indices.
First, buying a cap-weighted index involves negative exposure to the size and value factors and positive exposure to the momentum factor. These exposures may not always matter, but if there is a repeat of the tech bubble implosion of 2000, they will matter.
Second, given their liquidity needs, most large institutional investors have no choice but to adopt cap-weighted strategies. Investing billions in small caps or emerging markets is more expensive than trading large cap US stocks. Equal weighting may offer higher returns for long-term equity investors, but the majority of capital may not be able to access it.
If you liked this article, don’t forget to subscribe to the Enterprising investor.
All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
Image credit: ©Getty Images / Witthaya Prasongsin
Professional Learning for CFA Institute Members
CFA Institute members are empowered to self-determine and report professional learning (PL) credits earned, including content on Enterprising investor. Members can easily register credits using their HGV tracker online.