First, a little context. I think fund managers should implement their investment views as cost effectively as possible by introducing new techniques and instruments where they can.
Increasingly as the art of passive management is evolving, we have seen the use of various ‘smart passive strategies’.
One in particular that I’ve noticed is buying the equally weighted versions of a particular index as opposed to the usual market value-weighted index, such as the S&P 500 or the FTSE 100, which have traditionally dominated the world of passive management.
In a normal index the weight of each company reflects its market value. By comparison, in an equally weighted index all companies have the same weight. This means that all stocks in the index have equal potential to influence performance.
A level playing field for companies to contribute
An example might best illustrate how market values versus equal weighting differ. Let’s take the S&P 500 Index. The three biggest stocks in the market value weighted version of this index are currently Exxon Mobil, Apple and Google, with market cap weights of 2.8 per cent, 2.8 per cent and 1.9 per cent, respectively.
These have weights in the S&P equally weighted index of 0.2 per cent each; the bigger the company, the bigger the underweight.
At the other end of the spectrum is a very long tail of smaller stocks, such as AutoNation (drive-in, drive-out car maintenance centres), Nasdaq OMX group (stockmarkets) and The Gannett Company (media).
These have market values of about $5bn, which translates into market value-weights of about 0.03 per cent in the S&P 500. These weights would rise to 0.2 per cent in the equally weighted index.
There tend to be relatively few companies with market capitalisations higher than the average and a much larger number that have market capitalisations lower than the average.
As a result, there tends to be a comparatively small number of under-weights of very large companies and a larger number of over-weights of reasonably small companies in any equally weighted Index.
Potential benefits of using equally weighted version
In our example, the equally weighted version of the S&P 500 provides exposure to three additional sources of long-term returns, notwithstanding the fact that it and the market value version exhibit very high correlation. Those sources are:
■ Returns accruing to value stocks, as the equally weighted index tends to overweight stocks with low valuations and underweight stocks with high valuations;
■ Returns accruing to small-caps (relatively small caps in this case, as all stocks are still members of the S&P 500); and
■ Returns accruing to rebalancing, as the quarterly rebalancing process involves selling stocks that have done well and buying the stocks that have done badly (effectively a contrarian strategy).
In a world where clients are looking ever more closely at costs, this approach can help reduce management fees and trading costs – something we should all be working towards.
