INVESTMENT

Stock market crash equals- vs. market cap-weighted portfolio


Introduction

Bring diversification, reduce fees, avoid active trading and keep it simple.

Most investors will get better service by following the above structure. But while it is easy to recommend, this rubric is rather difficult to implement.

For example, how will an investor diversify in 2021? Over the past 40 years, a general equity and bond portfolio has done a great job of creating attractive risk-adjusted returns. There was not much need outside of these two resource classes. But with bond yields declining, fixed-income instruments have lost much of their luster. There are potential replacements – hedge fund strategies, for example – but these can be complex and expensive.

Indeed, there are no easy answers to other, even simpler resource allocation questions. Consider basic equity allocation. According to the structure, diversity across and within the asset class is important. For US-based investors, this means exposure to international and emerging markets. But which allocation formula should they apply? Market-cap or equal-weight? Probably factor based?

The same question applies to U.S. equity allocations. How should they be weighed? The biggest investors often have little choice. Considering their liquidity requirements, they must determine the market-cap weight. Smaller, more glossy investors, however, can allocate more to less liquid stocks.

Researchers have long compared the performance of equities and market cap-weighted equity strategies, but found no obvious sensitivities on which to prioritize. In the last two stock market crashes, towards the end of the Global Financial Crisis (GFC) and during the Covid-1 pandemic epidemic last year, the US stock market surpassed a market cap-weighted portfolio.

But the two data points are not statistically meaningful. So what about the previous recession? What was the equivalent- and market-cap-weighting in U.S. equities during the previous stock market crash?

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Performance direction

Comparisons of U.S. stock market design portfolios make the case for equal-weighting. Kenneth R. According to the French Data Library, the smallest 10% stock has done much better than the largest 10%. Since it represents the size factor, those familiar with factor investing will not find this result surprising.


CAGR per market-cap decile in the US stock market, 1926 to 2021

CAGR bar chart per market-cap decile in the US stock market, 1926 to 2021
Source: Kenneth R. French Data Library, Factor Research

Although small-cap performances were tempting in the years from small to 26, the extra returns were mostly made before 1981, when Ralph W. Banj published his original paper in small-cap stocks. Since then, small-cap performance has been rather lacking, so there is less enthusiasm among investors today about the size factor than in the past.

Moreover, these historical returns are back-tested rather than realized. And the smallest 10% of stock has small market capitalization and is not liquid enough for most investors. If the cost of the transaction is included, the theoretical income of the size factor will be significantly lower.

Since our focus is practical financial research, we will exclude the smallest stock by 20% from our analysis. This reduces the revenue of an equal weight strategy, but makes them more realistic.


U.S. stock market CAGRs, 1926 to 2021

The bar chart shows the US stock market CAGR, 1926 to 2021
Source: Kenneth R. French Data Library, Factor Research

Stock Market Crash: Equal vs. Market-Cap Weighted

One of the worst stock market crashes between 1922 and 2021, some had shorter periods of drowning, others were long bear markets that spanned more than a year. The collapse of this market was driven by a variety of factors ranging from wars and geopolitical conflicts to economic recessions, bubbles and epidemics.

Generally speaking, the drawdown of our new equal-weight portfolio and its market cap-weighted opponent was the same. However, in five cases – 1932, 1933, 1942, 1978 and 2002 – these were separated by 10% or more. In each instance, the equal-weight portfolio had small downsides.


Stock Market Crash: Equal-vs. Market Cap-Weighted Portfolio

Stock Market Crash Showing Chart: Equal-vs. Market Cap-Weighted Portfolio
Source: Kenneth R. French Data Library, Factor Research

Based on the chart above, investors can assume that portfolios of equal weight generally did well during the stock market downturn, but the average and median of the 90-year period were almost identical.

Although the risks are similar when comparing drawdowns, smaller companies tend to be a little more volatile than their larger counterparts. For example, there was a slightly higher volatility in the equivalent-weighted portfolio, 15% in the market cap-weighted portfolio.


Stock Market Crash, 1932 to 2021: Equal vs. Market Cap-Weighted Portfolio

Stock market crash, chart showing 1932 to 2021: Equal vs. market cap-weighted portfolio
Source: Kenneth R. French Data Library, Factor Research

More thoughts

Beyond the risk consideration, two other factors must be considered when evaluating the equivalent vs. market cap-weighted index.

First, buying a cap-weighted index means negative exposure to size and value factors and positive exposure to the momentum factor. These exposures may not always be significant, but they will be significant if the 2000 tech bubble burst repeats itself.

Second, based on their liquidity requirements, most large institutional investors have no choice but to adopt a cap-weighted strategy. It is more expensive to invest billions in small cap or emerging markets than to trade large-cap US stocks. Equal-weight equities may offer higher returns for investors in the long run, but most capital may not be able to access them.

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All posts are the author’s opinion. As such, they should not be construed as investment advice, or the opinions expressed must not reflect the views of the CFA Institute or the author’s employer.

Photo Credit: © Getty Images


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Nicholas Robben

Nicholas Robben is managing director of Factor Research, which provides quantitative solutions for factor investing. Previously he founded Jacada Capital, a quantitative investment manager that focused on equity market neutral strategies. Previously, Rabener focused on real estate across the property class at GIC (Singapore Investment Corporation Government). He started working for Citigroup at Investment Banks in London and New York. Rabner holds an MS in Management from the HHL Leipzig Graduate School of Management, is a CAIA charter holder, and enjoys endurance sports (100km ultramarathon, Mont Blanc, Mount Kilimanjaro).



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