Exposure to the Size Factor Drives Equal-Weight Outperformance

Examining the key drivers of equal-weighted portfolios outperforming value-weighted portfolios over multiple decades.

The key drivers of equal-weighted portfolios outperforming value-weighted portfolios over multiple decades in various investment universes was the focus of a Lancaster University study.

Equal-weighted portfolios invest an equal amount of money in each company’s stock that makes up the portfolio. In value-weighted portfolios, individual components of the portfolio are included in amounts that correspond to their total market capitalization, so that larger-company stocks receive a higher weight.

Between 1963 and 2021, an equal-weight portfolio comprising the entire universe of stocks outperformed similar value-weight portfolios by 3.5%; an equal-weight portfolio of S&P 500 index stocks outperformed by 2.2%.

The researchers found the size factor to be “the most significant driver of the performance” difference between the equal-weight and value-weight portfolios. The size factor refers to the long-term outperformance of small-company stocks relative to large-company stocks. The study further found a strong impact of size during January, when smaller-company stocks have tended to outperform.

The Effect of Equal-Weighting Across Sample Periods and Universes

The Effect of Equal-Weighting Across Sample Periods and Universes

Other factors at play are momentum (outperforming stocks tend to continue outperforming) and volatility. The spread (difference) between equal-weighted and value-weighted portfolios was found to be negatively correlated with momentum, due to the regular rebalancing used by equal-weight portfolios. Volatility was also shown to be negatively correlated with the spread.

In summary, over time an equal-weight portfolio has historically resulted in a higher return than that of a value-weight portfolio due to giving greater exposure to small-cap companies. Equal-weight portfolios rebalance more, which can provide a benefit from short-term reversals, but also have a negative result from momentum exposure.

Source: “Why do equally weighted portfolios beat value-weighted ones?,” by Alexander Swade, Sandra Nolte, Mark Shackleton and Harald Lohre; Lancaster University, 2022.