Equal-Weighting Versus Value-Weighting: Theory and Practice
30 Pages Posted: 24 Mar 2018
Date Written: May 19, 2017
Stocks exhibit higher expected returns when random mispricing presents (Brennan and Wang, 2010). Based on constituents of several major U.S. stock indexes from 2002 to 2016, we show that equally-weighted portfolios could benefit from this mispricing return premium and deliver abnormal returns to investors. Specifically, this outperformance could be realized after deducting trading costs and taxes when portfolio size is medium (e.g. $500 million in 2002 dollar) or smaller, but diminishes for larger portfolios. The findings of this paper suggest that, instead of relying on the popular value-weighted portfolios, investors could consider equal-weighting strategies for higher risk-adjusted returns. The implication is that current level of market inefficiency is sufficiently high so that simple equal-weighting strategies could generate positive abnormal returns.
Keywords: Indexing, Equally-Weighted Index, Stock Return Bias, Jensen’s Inequality, Capital Gains Tax
JEL Classification: G14, G23
Suggested Citation: Suggested Citation