Equal Weight Vs Market Weighting

Almost all benchmark indices are market-weighted.

Surveys for the S&P 500, which is market-weighted, show that an equal-weighted index has given a better return.

For example, in the S&P 500, Microsoft (MSFT) is the most weighted as of January 2019 with 3.71%, while Mattel (MAT) is the least with 0.01887%.

The 25 largest companies make up 35% of the market value, and Microsoft is weighted as much as the 110 smallest companies combined (!).

There are 500 shares in the index, but in practice, only the 50 largest companies make up the majority of the return. In an equal-weighted index, of course, all shares are given the same weight, ie 1/500.

The smaller companies intuitively have greater opportunities to grow. Therefore, balancing the S&P 500 has given a greater return than the market weight, ie a kind of “smallcap effect”.

In a note from Morgan Stanley in 2013, they constructed an equilibrium index back to 1926 based on data from the research article “The Cross-Section of Expected Stock Returns” written by Eugene Fama and Roger French. The following figure shows the result:

For almost 100 years, an equal-weighted index has outperformed the market-weighted index.

The figure given above is logarithmic, therefore the difference may seem small, but over a long period of time, it is enormous: approximately 2.8% more in an annual return for an equal-weighted index. This means that the value after 87 years corresponds to almost ten times more capital! This is the magic of compounding.