Equal- vs. Market-Cap Weighted Portfolios

Equal- vs. Market-Cap Weighted Portfolios

The general advice to diversify, reduce fees, avoid active trading, and to keep it simple is easier said than done—especially in 2021, contends an article in the CFA Institute Enterprising Investor Blog. A comparison between equal-weighted and market-cap portfolios for the last 95 years could hold a clue.

The largest investors often have little choice and must pursue market-cap weighting because of their liquidity requirements. But smaller investors can allocate more to less liquid stocks. There’s a long history of comparison between the two strategies and while market cap-weighted portfolios outperformed in the last two stock market crashes (GFC and COVID), there’s no clear consensus. In several stock market downturns since 1933, equal-weighted portfolios performed slightly better. And an equal-weighted portfolio had a slightly higher volatility: 16% vs the market cap-weighted portfolio’s 15%.

The article concludes with two risk factors to take into consideration. One, a cap-weighted index could imply positive exposure to the momentum factor and negative exposure to size and value factors—something that seems insignificant now, but if there’s a repeat of the tech bubble implosion of 2 decades ago, those exposures will matter. Two, since most large institutional investors have no choice but to adopt cap-weighted strategies, equal weighting may produce higher returns over the long run to equity investors—but most of capital won’t be able to access them.

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