Equally weighted indices are an increasingly popular alternative to traditional market capitalisation indices and are an example of smart beta index construction. Smart beta investment portfolios are rule driven strategies that aim to outperform a benchmark or reduce risk in a transparent way as an alternative to active management. Often smart beta indices use weightings based on something other than market capitalisation, such as the equally weighted index.
Market cap or equal weight
Most regional benchmark indices are weighted by market capitalisation. This method of index construction means that the resulting index is a good overall representation of the market in that it reflects each company’s size. An equally weighted version of an index will typically use the same universe of stocks but set weightings equally among them. This substantially changes the allocation across the basket of stocks with a seemingly simple mechanism. For example in the FTSE 100 index, the UK benchmark, the top 10 constituents account for approximately 40% of the index (July 2021) whereas in the equally weighted version of the same index the top 10 accounts for under 11% of the same index (10% on rebalancing). This fundamentally changes the index in terms of holdings, diversification and sector allocation.
By design equally weighted indices have a greater allocation to smaller companies than their market capitalisation counterparts. The ten smallest companies in the FTSE 100 make up only 2% of the index which is much less than the circa 10% they would account for in the equal weight version. Popular factor investing strategies such as seeking value typically point to companies at the lower end of the index. These are the companies that an investor would gain greater exposure to in an equal weight index.
Dividend yield and PE ratios are commonly used as value stock indicators therefore we can define value stocks to be those stocks in the FTSE-100 with a divided yield in the top 25% and a PE ratio in the lowest 25% of the universe. The ten most prominent “value” stocks in the FTSE 100 index account for 9.7% of the FTSE 100 Equally Weighted Index but only 6.9% of the FTSE 100 index.
| ||FTSE 100 Equally Weighted Total Return Index ||FTSE 100 Total Return Index ||FTSE Mid 250 Total Return Index |
|Average annualised return ||8.35% ||5.37% ||9.06% |
|Average Volatility ||17.23% ||16.78% ||16.96% |
|Return in 2020 ||-3.06% ||-12.28% ||-5.54% |
|Volatility in 2020 ||30.42% ||29.6% ||30.63% |
The table shows summary statistics for FTSE 100 index, FTSE 100 equally weighted index and the FTSE 250 index (the next 250 stocks below the top 100). In all cases the total return version of the indices were used and the period considered was the last five years (from 1 July 2016 to 30 June 2021).
Similar yet with power to outperform
The equally weighted version of the index has outperformed the FTSE 100 over the period at a slightly higher volatility The equal weight version significantly outperformed in 2020, a period of high volatility and big market shocks.
The correlation between the indices is high in all cases. The highest correlation is between the FTSE 100 Equally Weighted and the FTSE 250 and was 98.8% over the time period. This suggests that even though the basket of stocks is different between these indices, they can be very highly correlated.. Having a larger percentage in smaller stocks explains why the equal weighted version of the index has more similarities to a midcap index which is made up of smaller companies compared to a large cap index. The factor qualities attributed to mid cap indices (small size and value) are often the same as for equally weighted strategies.
The examples we have all looked at are equally weighted versions of well-known market capitalisation indices. It is worth noting that the selection for entry into both versions is based on market capitalisation i.e. the FTSE 100 is the largest 100 companies in the UK and the equal weight version also uses this as its universe. This is typical of smart beta strategies which take a natural universe as a starting point and overlay the desired strategy.
Place in structured products market
Despite their merits, currently equally weighted indices make up a relatively small proportion of structured product underlyings.
In Europe equally weighted strategies are more popular and accounted for 7.7% of sales in 2020. The largest index by sales was the Euronext Climate Objective 50 Euro EW Decrement 5% Index and the most frequently used as a product underlying was the Dow Jones Industrial Average Equal Weight Index which is unusual in that its base index is not weighted by market capitalisation but by price.
However In the US equal weight indices and ETFs accounted for less than 1% of sales in 2020. The most frequently used index was the Solactive Equal Weight Canada Banks 5% AR Index and the index with the highest sales volume was the Solactive Eurozone 50 Equal Weight 5% AR Index which was used as an underlying in combination with both the Russell 2000 and S&P 500 index. Source for all product issuance data from www.structuredretailproducts.com.
It is common for equal weight indices to also have a decrement or fixed dividend overlay in place. The main argument for decrement strategies is that they make pricing more straightforward for issuers as it removes the dividend risk which should feed through to better pricing for investors. However, depending on how the fixed dividend compares to the realised dividend will determine how the decrement strategy performs compared to the price return version of the index. Decrement strategies can make more sense in equal weight indices to avoid issues of dividend payments in smaller companies.
Giving investors easy access to underlyings or strategies which would otherwise be costly or impracticable is one of the merits of structured products. Equally weighted indices make a compelling alternative to market capitalisation indices and although it would not be practical for a significant slice of investment capital to be distributed in this way for liquidity reasons, equal weight indices are well suited to be used in structured products.
A version of this article has also appeared on www.structuredretailproducts.com
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