Why Have Equal-Weighted Portfolios Outperformed the Market?

Equal-weighted (EW) portfolios have outperformed market-capitalization-weighted portfolio, also referred to as value-weighted (VW) portfolios, over multiple decades across various investment universes. The simple, naive (1/N) approach of equally weighting portfolio constituents is a popular choice of academics doing research. EW’s outperformance has also attracted the interest of investors. For example, Invesco’s S&P 500® Equal Weight ETF (RSP), which like the S&P 500 Index is rebalanced quarterly, had assets of more than $33 billion as of November 2022. The fund’s expense ratio is 0.20%.

EW portfolios have greater exposure than VW portfolios to the CAPM market beta factor and the Fama and French size and value factors because small stocks have lower market capitalizations than larger stocks, and they also tend to have higher market betas; value stocks tend to have lower market capitalizations than growth stocks. Since the beta, size and value factors have provided premiums over the long term, the greater exposure to these factors could explain EW’s outperformance.

However, other factors could be at work as well.

Alexander Swade, Sandra Nolte, Mark Shackleton and Harald Lohre, authors of the November 2022 study “Why Do Equally Weighted Portfolios Beat Value-Weighted Ones?,” investigated the long-term evidence of the equal-weighted minus value-weighted (EW–VW) return spread in a broad U.S. equity universe across multiple factor models in order to determine the source of the historical outperformance of EW portfolios. They began by noting that the EW portfolio “requires rebalancing to maintain equal weights over time. At each rebalancing date, it sells winners and buys losers and is thus considered a mean-reversion, contrarian strategy. The deterministic weighting scheme does not require any expected return or variance input and intrinsically enables diversification. Therein, a naive investor is only reliant on the average correlation coefficient to determine acceptable risk-return trade-offs.”

Their sample period was July 1963-December 2021, and they used monthly data from CRSP and Compustat covering stocks traded on the NYSE, AMEX and Nasdaq. Over the full period they found that in the CRSP universe, EW returned 14.9% per annum at a volatility of 20.6%; and in the S&P 500 universe, EW returned 13.6% per annum at 17.1% volatility, providing higher returns than the two VW portfolios, which showed similar annual returns (11.4%) at about 15% volatility (see Exhibit 1 below). They also found that the EW portfolios provided higher returns than their VW counterparts in 33 (37) out of the 59 years. The higher returns were accompanied by higher risks in terms of higher volatility and more severe drawdowns. However, over the full period the EW portfolios produced higher Sharpe ratios (SR), as can be seen in Exhibit 2.