The US stock market has never been so top-heavy, and there appears to be no easy solution, if not no solution, inside investors’ reach. The peak of the dot-com bubble seems downright quaint in comparison with the present market structure, with the highest 10 weighting currently at a whopping 33.35% of market capitalization. The diversification dilemma is real.
My goals on this blog post are threefold. First, I’ll diagnose the disease that pervades the U.S. equity market. Second, I’ll examine why equal weighting—the popular reserve index strategy—skews a portfolio with exposures which might be removed from equal. Third, I’ll explain why an element application can naturally distribute portfolio weights for ideal diversification. The factor portfolio is more diversified than a market cap portfolio without the sensible and performance disadvantages of equal weighting.
Big money, greater problems
Mega-cap concentration has exploded, increasing 115% since its 25-year low in 2015, when the highest 10 holdings accounted for 15.52% of the overall index weight. After surpassing historical concentration levels of the dot-com bubble for the primary time in 2020, concentration now stands at a 38% premium to such excesses. US equities have long since crossed the concentration Rubicon.
The consequence of an increasingly top-heavy benchmark is that market diversification and breadth have never been more limited. This problem might be conceptualized by the effective variety of stocks provided by an index—the dimensions of an equally weighted basket that gives equivalent diversification.
Exhibition 1.
The startling conclusion is that while the Russell 1000 nominally offers exposure to its namesake variety of stocks, it actually offers effective diversification of just 59 stocks. This number represents a historic low, all the way down to just 29.2% of the effective holding number (N) of 202 stocks reached in 2014. Not only does market cap weighting introduce significant risk to individual stocks, however the diversification this fundamental asset class offers has shrunk by 70% over the past decade. Hence the concentration crisis.
Equal weight as a rescue? Unlikely…
If market-cap weighting pushes portfolios to their limits, cannot equal weighting of corporations achieve the diversification that investors demand? For the identical reasons that the market is so concentrated, the equal weighting method results in quite radical portfolio constructions, the outcomes of which could also be even less desirable than the concentration itself. This is a classic case of the cure being worse than the disease.
Annex 2.
This will not be the equal-weight market of your forefathers. What is commonly perceived as an easy alternative is not any longer a substitute benchmark, but an aggressive energetic strategy. Equal-weight strategies specifically suffer from significant operating costs, poor performance, questionable assumptions and distorted risk bets.
As the structure of market-cap and equal-weighted portfolios has diverged, tracking error has increased to eight.05% on an annualized basis. This is the best tracking error recorded outside of periods of market stress, despite volatility being only 21%.st percentile measured over a 20-year period. To illustrate how extreme this tracking error is, the 60 largest energetic mutual funds within the U.S. have a median tracking error of 5.50% on an annualized basis. Yes, that is right, due to their elaborate reallocation scheme, they’ve the identical weight because the leading energetic funds.
As an energetic strategy using cards, equal weight suffers from the well-known disadvantages of high turnover and poor performance. The have to smooth out all price movements at each rebalance signifies that the Russell 1000 Equal Weight Index has averaged two-sided turnover of 71.0% since 2000. Moreover, this turnover is historically inconsistent, starting from a low of 44% in 2012 to a high of 132% at the peak of the dot-com bubble. This inaccuracy is a recurring theme of the equal weighting strategy.
Annex 3.
But it’s the weakness of performance that almost all militates against the principle of equilibrium. When returns are so unevenly distributed, owning corporations equally is a dangerous approach. The mega-caps didn’t achieve their stratospheric concentration through poor performance.
In fact, the identical performance was maximized when the degree of market concentration was minimized. The happiest days of equal weighting were a decade ago, with absolutely the peak being reached on June thirtieth., 2014. Since then, the strategy has consistently underperformed in just about all market conditions.
Figure 3 illustrates this stark split in performance versus changes within the concentration of the highest 10 indices. While the Equal Weight Index outperformed by 405 basis points (bps) on an annualized basis from 2005 through mid-2014, it underperformed by nearly the identical amount (408 bps) over the following 10 years. In fact, for each one point increase within the concentration of the highest 10 indices from 2015 levels, the Russell 1000 Equal Weight Index lost 2.17 points in relative performance versus its market-weighted counterpart.
Betting on knowing nothing
Why has this gap between the equally weighted returns emerged since 2014? While capital weighting assumes efficient markets, where asset prices accurately reflect all information, the equally weighted return takes the other approach. It assumes that we cannot know the market.
If the concentration is at a manageable level, this assumption of “not knowing” continues to be very necessary, but a balanced weighting continues to be feasible. On the opposite hand, for the reason that market capitalization of the most important Companies to 7,658 times the common size of the ten smallest stocks within the Russell 1000, equal weighting of those corporations has long been inconceivable.
This size gap between the most important and smallest corporations will not be only emblematic of the concentration dilemma, but in addition a sign of why equal weighting fails on this market regime. In 2005, this size gap was 224 times, increased nine times to 2,018 times by 2015, after which widened one other 3.8 times to today’s level. This 34-fold increase in scale signifies that a greater calibrated approach to achieving portfolio breadth is required. Simply claiming that every one corporations are the identical cannot bridge this gap.
Consider a diversified solution
In times of hyperconcentration, equal weighting deviates radically from market fundamentals, and indeed a return to those fundamental characteristics can promote the more balanced portfolio that investors desire. By specializing in independent drivers of historical outperformance, a multifactor model can achieve more informed diversification along the lines of a structured risk profile.
Annex 4.
To illustrate the advantages of this approach, the Russell 1000 Comprehensive Factor Index has applied a hard and fast and equal tilt to every of the aspects value, quality, low volatility, momentum and small size. By re-allocating the weightings in line with risk premia – versus agnosticism – it manages to extend the portfolio’s effective N-value to 385, which represents a 554% improvement in market capitalization diversification.
In terms of performance, a whole factor package not only achieves one of the best performance years from 2005 to 2014, but even exceeds them in the next 10 years by an element of 1.17, and that is uncorrelated. This signifies that the multi-factor model can outperform the benchmark over all the history by an annualized 99 basis points, while the annualized underperformance of Equal-Weight is 10 basis points.
If you compare the important thing risk bets of equally weighted and multi-factor portfolios, the differences change into clear. More than performance, costs or naive diversification, it’s the confusing and unstable factor exposures that talk against equally weighted strategies. While, for instance, a moderate bias towards value and away from momentum can be expected for equally weighted corporations, the numerous underweighting of quality and low volatility may very well be an unwelcome surprise. Therein lies the underperformance.
In a concentrated market where capitalization weighting is under increasing pressure, equal weighting can be an obvious candidate for a more balanced portfolio. In reality, nonetheless, neutralizing the concentration created by equal weighting ends in a very unbalanced set of risk bets on the basic drivers of portfolio performance. By targeting equal exposure to those crucial risk premia, a multifactor method can provide a balancing equilibrium for U.S. equities when more traditional measures are insufficient.
