There is no doubt a time and a place for all “smart beta” indexes, where performance may exceed their market cap-weighted counterparts. So far, 2015 has been such a time for the US large cap Russell 1000Equal Weight Index, which posted a 4.6% return through the end of May, versus 3.7% for the Russell 1000 Index.
Among the many and varied smart beta index strategies that have emerged over the past decade, equal weight indexes were the earliest and arguably the least complex. With the objective of breaking the link between a stock’s price and its weight in the index, some of the first equal weight indexes took the simple approach of equally weighting all constituents. But this meant that the weight of each sector was determined solely by the number of companies in the sector, which could result in significant sector biases.
The Russell Equal Weight Index series methodology seeks to solve this problem by first of all equal weighting the sectors and then equal weighting the companies within each sector. As a result, the Russell 1000 Equal Weight Index—the US large cap index within the series—reflects the largest securities in the US equity market while maintaining diversification across sector groups.
A comparison of sector weights highlights how this equal-weighted approach can result in material differences from comparable cap-weighted indexes. As illustrated below, sector allocations as of last quarter end varied considerably between the Russell 1000 and Russell 1000 Equal Weight Index.
Source: Russell as of March 31, 2015. Past performance is no guarantee of future results.
Although sector exposures differed, data suggests that a key driver of year-to-date performance differences has not been the sector weights but rather how securities are weighted within each sector. This is evident when comparing the differences in sector returns for the year-to-date period ending April 30.
Source: Russell as of April 30, 2015. Past performance is no guarantee of future results.
The above data demonstrates that weighting the securities equally within each sector resulted in higher performance for several sectors. Most notably, the Health Care sector return for the Russell 1000 Equal Weighted Index exceeded that of the Russell 1000 by 3.5%, and for the Energy sector the differential was 8.2%.
A key contributor to strong relative performance for the Russell 1000 Equal Weight Index has been the size factor. Because the index spreads exposures evenly across the opportunity set, it avoids the concentration that can occur in market cap-weighted indexes where a few large companies can dominate index performance simply because of their size. That concentration can skew index results either positively or negatively.
Such data underscores how index composition differences can lead to a significant divergence in performance, and how equal weighting on both a sector and security level can at times affect performance relative to a market cap-weighted scheme.
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