Monday, December 5, 2011

Equally Weighted Index Performance

With less than a month left in 2011, a year that was supposed to be a great one for stock-pickers has turned out to be pretty unfavorable.  It has been reported that only 27% of active equity mangers are beating their benchmarks year to date.

Prior to looking at the data below, I thought that one of the reasons that so many managers were underperforming might be that the equally weighted indexes were underperforming the market weighted ones.  My hypothesis was that active managers' portfolios in aggregate resemble an equally weighted portfolio more than a market-cap weighted portfolio.  The equally weighted index represents the performance of an average stock, the market cap weighted one is skewed to represent the performance of the largest stocks.  This seems to represent the drivers of an actively managed portfolio more accurately because active managers tend to hold a subset of an index paying less attention to recreating the market cap weights than choosing best ideas.

The data that I used to test my hypothesis shows mixed results though.  If this year's underperformance can be explained by the equal weighting effect, then an equally weighted index should be underperforming its market cap weighted counterpart in 2011.  An equally weighted Russell 1000 is actually outperforming a market-cap weighted Russell though.  However, the equally weighted Russell 2000 is underperforming the market-cap weighted Russell 2000 by quite a bit.  So, smaller companies are certainly underperforming larger ones so far this year and this could explain some of the underperformance of active managers, but within the Russell 1000, the divergence isn't quite as clear.

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Even if it doesn't perfectly explain this years' performance, I thought the divergence of the equally weighted indices vs. market cap weighted ones over longer term horizons is really interesting to consider.  The difference in the Russell 1000 over the last 10 years is the difference between a 38% aggregate return and a 145% return.  

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