Equal weight investing, also known as equal weighted indexing, is an increasingly popular approach for investors looking to access the stock market. By allocating equal dollar amounts to each stock in an index, equal weight funds remove the influence of a small number of mega-cap companies. This can lead to improved returns with lower volatility compared to market capitalization weighted indexes like the S&P 500. Despite the conceptual appeal, equal weight portfolios come with complex mechanics and higher turnover and fees. Careful research is needed to determine if this strategy can enhance long-term portfolio performance.
Equal weight funds tilt toward smaller stocks with greater weighting
Unlike market cap weighted indexes, equal weight funds tilt toward smaller, cheaper stocks. For example, in a traditional S&P 500 index fund, the top 10 stocks would account for over 25% of assets. But in an equal weight equivalent, the largest 10 holdings would only be 2% each. This loading up on smaller stocks introduces a value and size factor tilt, which can boost returns over the long run. However, because smaller stocks experience greater volatility, maintaining equal weights requires higher turnover and trading costs.
Long-term outperformance has been attractive but inconsistent
Numerous research papers have found equal weighting historically beats cap weighting in the U.S. stock market. For example, a frequently cited study by R. Marotta shows equal weight portfolios outperformed market cap indexes by 1.5% annually from 1990 to 2011 with lower volatility. However, large cap growth stocks have dominated markets since 2011, making equal weight’s recent excess returns less impressive. More data is needed to determine if the long-term edge will persist as market leadership rotates.
Higher turnover and fees are a drag on net returns
While equal weight indexing seems simple in theory, maintaining precise equal stock weights in practice requires continuously rebalancing, often selling relative winners to buy relative losers. This turnover can be 5-10X higher than straightforward cap weighted funds, driving up trading expenses, capital gains taxes and impact on tracking error. After deducting the higher fees, much or all of equal weighting’s gross return advantage can disappear. Investors must model net returns to see if the added costs outweigh the benefits.
The verdict – use in moderation as part of core strategy
For most investors, an allocation to equal weight stocks can add useful diversification and tilt factor exposures. But higher costs suggest a moderate position size, held alongside other core index building blocks. Astute timing to capitalize on periods of small cap outperformance could further enhance results. But expectations for a ‘free lunch’ from equal weighting are unrealistic given the complex tradeoffs involved.
Equal weight investing offers conceptual appeal but somewhat inconsistent added value for stock investors. By avoiding over-concentration in mega caps, equal weight indexes provided excess returns over the past 30 years – but with additional volatility and costs. A thoughtful combination of theories and evidence is required to determine optimal usage of this strategy.