Episode 394: Equal Weight vs. Market Cap Weight Index Funds

What It Covers

Benjamin Felix, Dan Bortolotti, and Ben Wilson examine equal-weighted versus market-cap-weighted index funds, analyzing why equal-weighted S&P 500 funds have historically outperformed since the 1970s but underperformed by three percentage points annually over the past decade. They explore concentration concerns, factor exposures, rebalancing costs, and whether Dimensional's targeted approach offers superior factor exposure without equal-weighting's drawbacks.

Key Questions Answered

• •Historical Performance Context: Equal-weighted S&P 500 funds outperformed market-cap-weighted versions by nine basis points annualized since 2003 inception, but this advantage reversed dramatically in recent years. Over the past ten years, equal-weight returned 12.93% annually versus 15.73% for SPY, a three percentage point gap. The early outperformance occurred during periods when small-cap and value stocks performed well, particularly following the dot-com bust recovery period starting in 2003.
• •Factor Exposure Reality: Multifactor regression analysis reveals equal-weighted funds systematically overweight small-cap and value factors while maintaining significant negative momentum exposure. The strategy mechanically sells recent winners and buys recent losers during quarterly rebalancing, creating an anti-momentum position. This factor exposure, not equal-weighting itself, explains most historical outperformance. Investors seeking these exposures can access them more efficiently through purpose-built factor funds without equal-weighting's structural drawbacks.
• •Turnover and Trading Costs: Equal-weighted Canadian ETFs demonstrate ten times higher portfolio turnover compared to market-cap-weighted equivalents over five-year periods. While explicit trading expense ratios remain low at 0.01% or less, implicit costs from crossing bid-ask spreads accumulate significantly. Quarterly rebalancing requires selling appreciated positions back to equal weights and buying underperformers, generating continuous trading activity that market-cap-weighted funds avoid through natural weight adjustments as prices change.
• •Volatility and Risk Profile: Equal-weighted portfolios exhibit significantly higher fifteen-year standard deviation than market-cap-weighted equivalents due to overweighting smaller, more volatile companies. These funds maintain short positions in the low-volatility factor, emphasizing high-volatility stocks that markets theoretically price as riskier. While equal-weighting reduces concentration in mega-cap stocks, it introduces different risks through extreme over and underweights at individual security and sector levels, creating unintended sector bets investors may not want.
• •Dimensional Alternative Approach: Dimensional's Core Equity fund achieves similar small-cap and value factor exposures as equal-weighted funds while anchoring to market-cap weights, capping sector deviations, and implementing momentum screens to avoid selling recent winners. Since 2005, this approach outperformed equal-weighted funds with materially lower turnover and volatility. The strategy applies modest tilts from market-cap weights rather than naive equal-weighting, delivering factor exposure more efficiently without systematic momentum bets or excessive rebalancing requirements.
• •Concentration Concerns Misplaced: Historical data shows weak relationships between market concentration levels and subsequent ten-year returns in U.S. markets. Taiwan's market exceeded 40% concentration in top seven stocks in November 2015, then outperformed U.S. markets over the following decade. Current U.S. concentration, while at historical highs, does not reliably predict underperformance. Larger companies typically exhibit lower volatility than smaller firms, making concentrated large-cap exposure potentially less risky than equal-weighting's extreme overweights to small, volatile stocks.