Equal- vs. Market Cap-Weighted Portfolios in Stock Market Crashes

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Introduction

Diversify, reduce fees, avoid active trading and keep it simple.

Most investors would be well served by following the above framework. But it’s easy to recommend, but it’s difficult to apply this rubric.

For example, how does an investor diversify in 2021? Over the past 40 years, a simple equity and bond portfolio has done a great job of generating attractive risk-adjusted returns. There was no need for more than these two asset classes. But with the decline in bond yields, fixed-income instruments have lost their sheen. There are potential replacements – hedge fund strategies, for example – but these can be complex and expensive.

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In fact, there are no easy answers to other, even simpler asset allocation questions. Consider basic equity allocation. As per the framework, diversification within and across asset classes is important. For US-based investors, this means investing in international and emerging markets. But which allocation formula should they apply? Market-cap or Equal-weighted? Maybe factor based?

The same question lies within US equity allocation. How should they be weighted? The biggest investors often have little choice. Given their liquidity requirements, they should pursue market-cap weighting. However, smaller, more nimble investors can invest more in less liquid stocks.

Researchers have long compared the performance of similar and market cap-weighted equity strategies, but there has been no clear consensus on which is better. In the last two stock market crashes, late last year during the global financial crisis (GFC) and last year during the COVID-19 pandemic, a market cap-weighted portfolio outperformed the US stock market.

But the two data points are hardly statistically meaningful. So what about the previous recession? How have US equities fared similarly and market cap-weighting performance during the last stock market crash?

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performance aspect

Comparing portfolios that have declined in the US stock market makes the case for equal weighting. Kenneth R. According to data from the French Data Library, the smallest 10% of stocks outperformed the largest 10%. Since it represents the size factor, people familiar with factor investing will hardly find this result surprising.


CAGRs in the US Stock Market from 1926 to 2021 per Market-Cap Decile

Bar chart of the CAGR per market-cap decibel in the US stock market, 1926 to 2021
Source: Kenneth R. French Data Library, Factor Research

Although small-cap performance has been attractive in the 90 years since 1926, the excess return was mostly generated before 1981, when Rolf W Bunge publishes his seminal paper on small-cap stocks. Since then, small-cap performance has been pretty weak, so there’s less enthusiasm for the size factor among investors today than it was before.

Furthermore, these historical returns are back-tested rather than realized. And the smallest 10% of stocks have small market capitalizations and are not liquid enough for most investors. If transaction costs are included, the theoretical benefit of the size factor would be quite small.

Since our focus is on applied financial research, we will exclude the bottom 20% of the smallest stocks from our analysis. This dilutes the returns of equal-weighted strategies, but also makes them more realistic.


US Stock Market CAGR, 1926 to 2021

Bar chart showing US stock market CAGR, 1926 to 2021
Source: Kenneth R. French Data Library, Factor Research

Stock Market Crash: Equal Vs. Market-Cap Weighted

Some of the 18 worst stock market crashes between 1926 and 2021, such as the 1987 fall, were short in duration, while others were long bear markets that extended for more than a year. These market declines were driven by a variety of reasons, from war and geopolitical conflict to an economic downturn, bubbles and a pandemic.

Broadly speaking, our new equal-weighted portfolio and its market cap-weighted counterpart had similar constraints. However, in five cases – in 1932, 1933, 1942, 1978 and 2002 – they diverged by 10% or more. In each instance, there was a small drop in the equally-weighted portfolio.


Stock Market Crash: Equal- vs Market Cap-Weighted Portfolios

Chart Showing Stock Market Crashes: Equal- Vs. Market Cap-Weighted Portfolios
Source: Kenneth R. French Data Library, Factor Research

Based on the chart above, investors can assume that an equally-weighted portfolio outperformed during stock market downturns in general, but the average and average were roughly the same over the 90-year period.

Although the risk is similar when comparing declines, smaller companies tend to be slightly more volatile than their larger peers. As such the equal-weighted portfolio had slightly higher volatility, 16% to 15% of the market cap-weighted portfolio.


The Stock Market Crash, 1932 to 2021: Equivalent vs. Market Cap-Weighted Portfolios

Chart showing the Stock Market Crash, 1932 to 2021: Equivalent vs. Market Cap-Weighted Portfolios
Source: Kenneth R. French Data Library, Factor Research

further thoughts

Beyond risk considerations, two other factors should be taken into account when evaluating similar versus market cap-weighted indices.

First, buying a cap-weighted index implies negative exposure to the size and price factors and positive exposure to the momentum factor. These exposures may not always be significant, but they will matter if the 2000 tech bubble explosion recurs.

Second, depending on their liquidity requirements, most large institutional investors have no choice but to adopt cap-weighted strategies. It is more expensive to invest billions in small-cap or emerging markets than it is to trade large-cap US stocks. Equal-weighting may offer higher returns for equity investors over the long term, but most of the capital may not be able to reach them.

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All posts are the views of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of the CFA Institute or the author’s employer.

Image Credits: © Getty Images / Wittaya Prasongsin


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Nicholas Rabner

Nicolas Rabner is the Managing Director of Factor Research, which provides quantitative solutions for factor investing. Previously he founded Jackdaw Capital, a quantitative investment manager focused on equity market neutral strategies. Prior to this, Rabner worked at GIC (Government of Singapore Investment Corporation), which focused on real estate across asset classes. He began his career working for Citigroup in investment banking in London and New York. Rabner holds an MS in Management from the HHL Leipzig Graduate School of Management, is a CAIA charter holder, and enjoys endurance sports (100 km ultramarathon, Mont Blanc, Mount Kilimanjaro).



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