Why Does an Equal-Weighted Portfolio Outperform Value- and Price-Weighted Portfolios?
Goethe University Frankfurt am Main
EDHEC Business School; Centre for Economic Policy Research (CEPR)
University of Mannheim
October 16, 2012
We compare the performance of equal-, value-, and price-weighted portfolios of stocks in the major U.S. equity indices over the last four decades. We find that the equal-weighted portfolio with monthly rebalancing outperforms the value- and price-weighted portfolios in terms of total mean return, four factor alpha, Sharpe ratio, and certainty-equivalent return, even though the equal-weighted portfolio has greater portfolio risk. The total return of the equal-weighted portfolio exceeds that of the value- and price-weighted because the equal-weighted portfolio has both a higher return for bearing systematic risk and a higher alpha measured using the four-factor model. The nonparametric monotonicity relation test indicates that the differences in the total return of the equal-weighted portfolio and the value- and price-weighted portfolios is monotonically related to size, price, and idiosyncratic volatility. The higher systematic return of the equal-weighted portfolio arises from its higher exposure to the market, size, and value factors. The higher alpha of the equal-weighted portfolio arises from the monthly rebalancing required to maintain equal weights, which is a contrarian strategy that exploits reversal in stock returns; thus, alpha depends only on the monthly rebalancing and not on the choice of initial weights.
Number of Pages in PDF File: 55
Keywords: stock index, systematic risk, idiosyncratic risk, factor models, contrarian, trend following
JEL Classification: G11, G12working papers series
Date posted: March 21, 2011 ; Last revised: October 18, 2012
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