Indexes are an incredibly important part of the financial markets. They provide an up-to-date, day-to-day view of market sentiment and are used as a benchmark to judge fund managers.

However, despite their importance, the construction of indexes is still relatively rudimentary. The S&P 500, for example, is a market capitalisation-weighted index, which has significant drawbacks. Indeed, empirical analysis suggests that the built-in momentum effect inherent in cap-weighted indices leads to heavily concentrated portfolios. This has the impact of masking the index’s actual underperformance. For example, in 2015 the S&P 500 register positive performance but this performance was attributed to just four main stocks, Facebook, Amazon, Google and Netflix excluding these FANGs the index would have registered a decline for the year.

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Beat The S&P 500 By Buying The S&P 500

The drawbacks of market cap weighted indices have sparked debate on whether equal weighted portfolios, with the same allocation to each constituent, would lead to a better risk-adjusted performance.

The answer to this question has been provided by the Index Funds S&P 500 Equal Weight fund. This fund aims to track the S&P 500® Equal Weight Index, which contains the same stocks as the S&P 500 but every constituent is allocated the same weight at each quarterly rebalancing. All equities in the Equal Weight Index are allocated the same weight compared to the S&P 500 where the largest 50 companies make up close to 50% of the index’s performance.

Baupost: Making Use Of Market Inefficiencies To Find …

The interesting thing is that the S&P 500 Equal Weight Index has actually outperformed the index it was designed to track. As a result, investors can (potentially) beat the S&P 500 simply by buying a derivative of the index itself — yet another blow to active fund managers.

How The Beat The S&P 500 By Buying The S&P 500
How The Beat The S&P 500 By Buying The S&P 500

Over the past 12 months, the Index Funds S&P 500 Equal Weight fund has produced a total return of 14.11%, compared to a return for the S&P 500 Total Return Index of 11.96%. Since 1 August 2003, a $10,000 investment in the S&P 500 traditional cap-weighted index would have turned $10,000 into $32,788 while a similar investment in the equal weighted index has turned into $44,615, an outperformance of 36.1%.

Writing in the Financial Times back in 2010, Robert Ferguson, senior investment officer at Intech and David Schofield is president of Intech International, speculate that the reason why equal weighted indices tend to outperform their market cap weighted peers is due to the “buy high sell low” nature of the benchmarks.

It has long been thought that the outperformance of equal-weighted portfolios versus cap-weighted portfolios is due to the “small-stock effect” as small stocks generally outperform large caps. However, Ferguson and Schofield believe the outperformance is “a consequence of the trading rule required to maintain equal weights, which is to buy after a negative relative return and to sell after a positive.” This trading rule has a “buy low/sell high” character, which “generates outperformance”.

It’s hard to argue with these figures, although caveat emptor.

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