Q&A with IFA: Equally-Weighted S&P 500 Index


Question: I have heard that an equally-weighted version (as opposed to the standard market cap-weighted version) of the S&P 500 Index achieves a higher return without additional risk. Should I not use this for the U.S. large cap component of my portfolio?

Our data on the equal-weighted version of the S&P 500 Index goes back 25 years, and over that period, it has gotten a higher return than the standard S&P 500 Index, but with a higher level of volatility. To determine if the difference in returns is statistically significant (i.e., not explained by random variations or the noisiness of returns), we performed a t-test on the annual returns which gave us a value of 1.18, indicating that the difference is not significant at a 95% confidence level.

In looking at the difference in the construction methodology of these two indexes, it is clear that the equally-weighted version would have a lower average size (i.e., it is more tilted towards smaller companies). Furthermore, it also ends up having a stronger tilt towards value stocks. Since size and value are two well-known compensated risk factors, we decided to construct a portfolio of IFA Indexes that has similar factor exposures as the equally-weighted S&P 500 Index. We found that a blend of 60% IFA U.S. Large Company and 40% IFA U.S. Small Cap Value Index has similar a size and value exposure, and it achieved almost the same annualized return as the equally-weighted S&P 500 Index. Please note that the 60/40 blend is not an investment recommendation.

Reward and Risk of Various Indexes
25 Years (1/1/1990 to 12/31/2014)
  Annualized Return Annualized Standard Deviation
Standard S&P 500 Index 9.62% 14.64%
Equally-Weighted S&P 500 11.46% 16.42%
Blend of IFA Indexes*
11.36% 15.53%

We also tested for alpha by running a three-factor regression against the risk factors of market, size, and value. After accounting for the returns explained by exposure to the three risk factors, there is no alpha.

Three-Factor Regression Results For Various Indexes
24 Years and 11 Month (1/1/1990 to 11/30/2014)
  Standard S&P 500 Index Equally-Weighted S&P 500 Index Blend of IFA Indexes*
Monthly Alpha 0.01 0.01 0.02
t-Stat of Alpha 0.27 0.10 0.40
Market Exposure 1.00 1.08 1.03
Size Exposure -0.18 0.03 0.14
Value Exposure 0.04 0.35 0.31

Since the returns of the equally-weighted S&P 500 Index can be essentially captured with a blend of cap-weighted index funds and the least expensive version that we know about costs 0.40% (Guggenheim S&P 500 Equal Weight ETF which has a turnover ratio of 18% compared to 3% for a standard S&P 500 Index fund), we do not see any compelling reason for investors to have it in their portfolios.