introduction
Diversify, reduce fees, avoid lively trading and keep it easy.
Most investors could be well advised to follow the framework outlined above. However, while this approach is straightforward to recommend, it is kind of difficult to implement.
For example, how does an investor diversify in 2021? Over the past 40 years, a straightforward portfolio of stocks and bonds has done a wonderful job of generating attractive risk-adjusted returns. There hasn’t been much need for anything beyond those two asset classes. But with bond yields falling, fixed income instruments have lost much of their luster. There are potential replacements – hedge fund strategies, for instance – but these might be complex and expensive.
In fact, other, even simpler questions on asset allocation haven’t any easy answers either. Let’s consider basic equity allocation. According to this framework, diversification each across and inside asset classes is essential. For U.S. investors, this implies exposure to international and emerging markets. But what allocation formula should they use? Market cap or equally weighted? Perhaps factor-based?
The same query arises when allocating US equities. How should they be weighted? The largest investors often have little selection. Given their liquidity needs, they need to aim for market capitalization weighting. However, smaller, more flexible investors can invest more in less liquid stocks.
Researchers have long compared the performance of equal- and market-cap-weighted equity strategies, but there isn’t any clear consensus on which strategy is preferable. In the last two stock market crashes, through the global financial crisis (GFC) within the late 2000s and the COVID-19 pandemic last yr, a market-cap-weighted portfolio outperformed the U.S. equity market.
But two data points are hardly statistically meaningful. So what about previous downturns? How have the weightings of stocks by market capitalization and by market capitalization developed during previous stock market crashes?
Performance points
A comparison of the decile portfolios of the US stock markets suggests equal weighting. According to data from the Kenneth R. French Data Library, the smallest 10% of stocks performed a lot better than the biggest 10%. Since that is the dimensions factor, this result should come as no surprise to those aware of factor investing.
CAGRs per market capitalization decile within the US stock market, 1926 to 2021
Although the performance of small-cap stocks over the 90 years since 1926 is enticing, the surplus returns were mostly achieved before 1981, when Rolf W. Banz published his groundbreaking paper on small-cap stocksSince then, the performance of small-cap stocks has been fairly mediocre, so investors’ enthusiasm for the dimensions factor is way lower today than prior to now.
Moreover, these historical returns are backtested fairly than realized. And the smallest 10% of stocks have tiny market capitalizations and usually are not liquid enough for many investors. The theoretical returns from the dimensions factor could be significantly lower if transaction costs were included.
Because our focus is on practical financial research, we exclude the underside 20% of smallest stocks from our evaluation. This reduces the returns of an equal-weighted strategy, but additionally makes it more realistic.
CAGRs of the US stock market, 1926 to 2021
Stock market crashes: equal vs. market capitalization weighted
Of the 18 worst stock market crashes between 1926 and 2021, some were short-lived, just like the 1987 crash, while others were long bear markets that lasted well over a yr. These market declines had quite a lot of causes, from wars and geopolitical conflicts to economic recessions, bubbles, and a pandemic.
Overall, the losses of our recent equal-weighted portfolio and its market-cap-weighted counterpart were similar. However, in five cases – 1932, 1933, 1942, 1978, and 2002 – they differed by 10% or more. In each case, the equal-weighted portfolio had smaller losses.
Stock market crashes: balanced vs. market capitalization weighted portfolios
Based on the chart above, investors might assume that equally weighted portfolios generally performed higher during stock market downturns. In fact, the typical and median were nearly similar over the 90-year period.
Although the chance is analogous when comparing declines, smaller corporations are likely to be barely more volatile than their larger peers, so the equal-weighted portfolio had barely higher volatility, 16% versus 15% for the market-cap weighted portfolio.
Stock market crashes from 1932 to 2021: balanced vs. market capitalization weighted portfolios
Further considerations
In addition to risk considerations, two additional aspects have to be taken under consideration when evaluating equally weighted and market capitalization weighted indices.
First, buying a capitalization-weighted index implies negative exposure to the dimensions and value aspects and positive exposure to the momentum factor. These exposures may not all the time be significant, but when there’s a repeat of the 2000 tech bubble implosion, they may matter.
Second, most large institutional investors haven’t any selection but to pursue capital-weighted strategies on account of their liquidity needs. Investing billions in small caps or emerging markets is dearer than trading large-cap U.S. stocks. Equal weighting can offer equity investors higher returns over the long run, but the vast majority of capital may not have access to it.
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Photo credit: ©Getty Images / Witthaya Prasongsin
