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

Introduction

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

Most investors would be well served by following the framework above. But while it is easy to recommend, this rubric is quite difficult to implement.

For example, how does an investor diversify in 2021? Over the past 40 years, a simple portfolio of stocks and bonds did a fabulous job of generating attractive risk-adjusted returns. It didn’t take much beyond these two asset classes. But with bond yields falling, fixed income instruments have lost much of their luster. There are potential replacements (hedge fund strategies, for example), but they can be complex and expensive.

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In fact, other, even simpler, questions about asset allocation also have no easy answers. Consider basic capital allocation. According to the framework, diversification, both between and within asset classes, is critical. For US-based investors, this means exposure to international and emerging markets. But which allocation formula should they apply? Market capitalization or equal weighting? Maybe based on factors?

The same question applies to US capital allocations. How should they be weighted? Larger investors often have little choice. Given their liquidity requirements, they should look for a market capitalization weighting. Smaller, nimbler investors, however, may allocate more to less liquid stocks.

Researchers have long compared the performance of equity-weighted and market-cap-weighted strategies, but no clear consensus has been reached as to which is preferable. In the last two stock market crashes, during the Global Financial Crisis (GFC) at the end of the year and the COVID-19 pandemic last year, a market capitalization weighted portfolio outperformed the stock market north american

But two data points have almost no statistical significance. So what about the previous falls? How have equity and market capitalization weights in US stocks fared during previous stock market declines?

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Performance aspects

A comparison of the decile portfolios of the US stock markets justifies the equal weighting. The smallest 10% of stocks did much better than the largest 10%, according to data from the Kenneth R. French Data Library. Because this represents the size factor, those familiar with factor investing would hardly find this surprising result.


CAGR by market capitalization decile in the US stock market, 1926 to 2021

Bar chart of CAGR by market capitalization decile in the US stock market, 1926 to 2021
Source: Kenneth R. French Data Library, FactorResearch

Although small-cap performance has been attractive over the 90 years since 1926, excess returns were generated primarily before 1981, when Rolf W. Banz published his seminal paper on small-cap stocks . Since then, the performance of small caps has been rather lackluster, so there is much less enthusiasm for the size factor among investors today than in the past.

Moreover, these historical returns are tested rather than realized. And the smallest 10% of stocks have minuscule market caps and aren’t liquid enough for most investors. The theoretical returns to size factor would be significantly lower if transaction costs were included.

Because our focus is hands-on financial research, we exclude the bottom 20% of the smallest stocks from our analysis. This lowers the returns of an equal weight strategy, but also makes them more realistic.


CAGR of the US stock market, 1926 to 2021

Bar chart showing US stock market CAGRs from 1926 to 2021
Sources: Kenneth R. French Data Library, FactorResearch

Stock market declines: weighting equal to market capitalization

Of the 18 worst stock market crashes between 1926 and 2021, some, like the 1987 crash, were short-lived, while others were long bear markets that spanned more than a year. These market declines were driven by a variety of causes, from wars and geopolitical conflicts to economic recessions, bubbles and a pandemic.

The reductions in our new equal-weighted portfolio and its market-cap-weighted counterpart were broadly similar. However, in five cases—1932, 1933, 1942, 1978, and 2002—they diverged by 10% or more. In each case, the equal-weighted portfolio had smaller write-offs.


Stock market declines: Equally weighted market capitalization portfolios

Chart showing stock market declines: equal market capitalization weighted portfolios
Sources: Kenneth R. French Data Library, FactorResearch

Based on the chart above, investors might assume that equally weighted portfolios did better during stock market declines in general, but the mean and median over the 90-year period were nearly identical.

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


Stock Market Crashes, 1932 to 2021: Equal Market Cap Weighted Portfolios

Chart showing stock market declines, 1932 to 2021: equal portfolios versus market cap-weighted portfolios
Sources: Kenneth R. French Data Library, FactorResearch

Additional thoughts

Beyond risk considerations, two other factors should be considered when evaluating market capitalization-weighted indexes.

First, buying a cap-weighted index involves negative exposure to the size and value factors and positive exposure to the momentum factor. These exposures may not always be significant, but if there is a repeat of the 2000 tech bubble implosion, they will matter.

Second, based on their liquidity requirements, most large institutional investors have no alternative but to adopt cap-weighted strategies. Investing billions in small caps or emerging markets is more expensive than trading large-cap US stocks. Equal weighting can offer higher returns for long-term equity investors, but most capital may not be able to access it.

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

Image credit: ©Getty Images / Witthaya Prasongsin


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Nicholas Rabener

Nicolas Rabener is the CEO of FactorResearch, which provides quantitative solutions for factor investing. He previously founded Jackdaw Capital, a quantitative investment manager focused on equity market neutral strategies. Previously, Rabener worked at GIC (Government of Singapore Investment Corporation) focusing on real estate across asset classes. He began his career working for Citigroup in investment banking in London and New York. Rabener holds a master’s degree in management from the HHL Leipzig Graduate School of Management, holds the CAIA charter and enjoys endurance sports (100 km Ultramarathon, Mont Blanc, Mount Kilimanjaro).

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