What happens when you turn market cap-weighting on its head?

One analysis takes a look at how a ‘reverse’ index would chart against conventional benchmarks

What happens when you turn market cap-weighting on its head?

It’s well known that weighting stocks according to their market capitalizations leads to some degree of inefficiency, and following an equal-weight methodology attenuates some of that friction in performance. But what happens when a portfolio goes a step further?

In a blog post published by S&P Dow Jones Indices (SPDJI), Josh Blechman, director of Capital Markets at Exponential ETFs, noted that fewer than 17% of active funds managed to outperform the S&P 500 (SPX) over the five-year period up to December 31, 2018. However, the passive S&P Equal Weight Index (SPEWI), outperformed the S&P 500 in 13 of 19 years from 2000 to 2018.

“Through selling winners and buying losers to parity each quarter, equal-weighting attempts to address a core inefficiency of cap weighted indices, which by definition – systematically over-weight, overvalued companies,” Blechman wrote, adding that market-cap indexes take the mathematical loss over time.

He then goes one better than the SPEWI benchmark by turning to the Reverse Cap Weighted Index (Reverse), which reverses the order of SPX by weighting each stock based on the inverse of its market cap. Reverse, by definition, systematically over-weights undervalued companies.

“Historically, in environments in which SPEWI outperforms SPX, we would expect Reverse to outperform them both,” Blechman said. Given that the SPX has outperformed SPEWI over the past three years, he noted, the opposite would be expected: Reverse should end up being the worst performer among the three.

Using historical Bloomberg data covering the timeframe from December 31, 1996 to June 30 this year, Blechman charted the performance of the three indexes over the period. The S&P 500 reportedly managed to get annualized returns of 8.34%, with annualized volatility of 18.92%; SPEWI had a slightly higher 10.14% annualized return with 19.63% volatility; and Reverse had 11.19% annualized return with 22.04% volatility.

He then looked at the daily five-year rolling returns of the three indexes from December 31, 2001 to June 30 this year. In 78% of the observed data points, Blechman said, Reverse was the highest-returning index among the three. He attributed the additional return of Reverse, and its relationship to SPEWI, in part to the higher size, value, and anti-momentum factor loads in the Reverse index compared to the other S&P weighting schemes.

“Reverse merely places additional load on the factors that drive differentiation between SPEWI and SPX,” he said, adding that such findings — as they relate to SPEWI and SPX — are in line with prior SPDJI research.

“While SPX represents an operationally efficient index, Reverse takes the well understood elements of SPEWI (which exploit the investment inefficiencies of Cap Weighting), one step further and provides a unique contrarian play within the S&P 500 universe,” Blechman concluded.


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