Beyond Equal Weighting: Reverse Cap Weighting the S&P 500

Consistently outperforming the S&P 500® is difficult. The S&P Dow Jones Indices SPIVA report shows that less than 18% of funds outperformed the S&P 500 (SPX) over the five-year period ending 12/31/2018. So how is it that the S&P 500 Equal Weight Index (SPEWI), a passive index comprised of the very same 500 stocks, accomplished what so few active managers have been able to do, outperforming the S&P 500 in 13 of 19 years from 2000-2018[1]? And how can understanding the nature of that outperformance yield further portfolio innovation?

Through selling winners and buying losers to parity each quarter, equal-weighting attempts to address a core inefficiency of cap weighted indices, which by definition – systematically over-weight, overvalued companies. While it is impossible to identify ahead of time which companies are the overvalued ones, the index should take the mathematical loss over time.

When viewed through this lens, it’s apparent that exploiting the allocation inefficiency of Cap Weighting through Equal Weighting is only a half measure.

The opposite of “Cold” isn’t “Room Temperature,” it’s “Hot.”

The Reverse Cap Weighted Index (Reverse), which as the name implies – reverses the order of the S&P 500 through weighting by 1/Mkt Cap, takes exploiting that inefficiency one step further. In direct contrast to Cap Weighting, Reverse by definition – systematically over-weights undervalued companies.  More information on Reverse Cap Indexing can be found here. The net result of weighting a portfolio in this manner is effectively a contrarian play within the S&P 500, as the largest companies/industries in SPX would be the lowest weighted within the Reverse Index.

Historically, in environments in which SPEWI outperforms SPX, we would expect Reverse to outperform them both. Conversely, in environments where SPX outperforms SPEWI (as is the case over the last three years) we would expect Reverse to be the worst performing of the three. Below is a chart detailing the performance of the three indices from 12/31/1996 – 6/30/2019.

Note: S&P EWI has an index launch date of 1/8/2003 and Reverse has an Index launch date of 10/23/2017. Both Indices are licensed and calculated by S&P Dow Jones Indices and all information for the Indices prior to its Launch Date is back-tested by S&P DJI, based on the methodology that was in effect on the Launch Date. Standardized performance for S&P 500, S&P EWI, and REVERSE can be found by clicking the respective link. Risk & Return data sourced from Bloomberg. All figures represent Total Return of the indices.

Consistent with this expectation, just as SPEWI has outperformed SPX with additional volatility, Reverse was the best performing of the three alongside the highest volatility of group. While the total return figure demonstrates the robustness of the outperformance, the below daily 5-year rolling return chart shows the consistency of that outperformance, with Reverse being the highest returning of the three indices in 78% of the observed data points.

Note: S&P EWI has an index launch date of 1/8/2003 and Reverse has an Index launch date of 10/23/2017. Both Indices are licensed and calculated by S&P Dow Jones Indices and all information for the Indices prior to its Launch Date is back-tested by S&P DJI, based on the methodology that was in effect on the Launch Date. Standardized performance for S&P 500, S&P EWI, and REVERSE can be found by clicking the respective link. Risk & Return data sourced from Bloomberg.

This additional return (and the relationship to SPEWI) is partially derived from the higher Size (SMB), Value (HML) and Anti-Momentum (MOM) factor loads expressed in the Reverse Index, relative to the other S&P weighting schemes. Reverse merely places additional load on the factors that drive differentiation between SPEWI and SPX. These findings (as they relate to SPEWI and SPX) are consistent with prior S&P DJI research.[2]

Note: S&P EWI has an index launch date of 1/8/2003 and Reverse has an Index launch date of 10/23/2017. Both Indices are licensed and calculated by S&P Dow Jones Indices and all information for the Indices prior to its Launch Date is back-tested by S&P DJI, based on the methodology that was in effect on the Launch Date. Standardized performance for S&P 500, S&P EWI, and REVERSE can be found by clicking the respective link. Fama-French factor portfolios are from the Ken French Data Library.

While SPX represents an operationally efficient index, Reverse takes the well understood elements of SPEWI (which exploit the investment inefficiencies of Cap Weighting), one step further and provides a unique contrarian play within the S&P 500 universe.

[1] Calendar year returns were calculated from 2000 through 2018.

[2] Edwards, T., Lazzara, C., Preston, H., and Pestalozzi, O. “Outperformance in Equal-Weight Indices.” S&P Dow Jones Indices LLC. January 2018.

Disclosure:
The author is an employee of Exponential ETFs, the creator and owner of the Reverse Cap Weighted U.S. Large Cap Index (the “Index”). Exponential ETFs has contracted with S&P Opco, LLC (a subsidiary of S&P Dow Jones Indices LLC) to calculate and maintain the Index. The Index is not sponsored by S&P Dow Jones Indices or its affiliates or its third-party licensors (collectively, “S&P Dow Jones Indices”). S&P Dow Jones Indices will not be liable for any errors or omissions in calculating the Index. “Calculated by S&P Dow Jones Indices” and the related stylized mark(s) are service marks of S&P Dow Jones Indices and have been licensed for use by Exponential ETFs. S&P® is a registered trademark of Standard & Poor’s Financial Services LLC (“SPFS”), and Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”).
The Reverse Cap Weighted U.S. Large Cap Index (Reverse) is a rules-based reverse capitalization weighted index comprised of the 500 leading U.S.-listed companies as measured by their free-float market capitalization contained within the S&P 500 universe. The Index has an inception date of October 23, 2017, with a back tested time-series inception date of December 31, 1996. You cannot invest directly in an index.
The S&P 500 Index is a widely recognized capitalization-weighted index of 500 common stock prices in U.S. companies. You cannot invest directly in an index.
The S&P 500 Equal-Weight Index is the equal-weight version of the widely-used S&P 500. The index includes the same constituents as the capitalization weighted S&P 500, but each company in the S&P 500 EWI is allocated a fixed weight – or 0.2% of the index total at each quarterly rebalance. You cannot invest directly in an index.
Past performance of an index is not a guarantee of future results, which may vary. The value of investments may go down as well as up and potential investors may not get back the amount originally invested. Performance figures contained herein contain both hypothetical and live returns; results, hypothetical or otherwise, are intended for illustrative purposes only. Index performance returns do not reflect any management fees, transaction costs, or expenses, which would reduce returns. Inclusion of a security within an index is not a recommendation by to buy, sell, or hold such security, nor is it considered to be investment advice. It is not possible to invest directly in an index.
The Index, strategy, and performance returns discussed are for informational purposes only and do not represent an offer to buy or sell a security and should not be construed as such.

The posts on this blog are opinions, not advice. Please read our disclaimers.

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