Why Has the Equal Weight Portfolio Underperformed and What Can We Do About It?
17 Pages Posted: 18 Jun 2020
Date Written: May 23, 2020
It is widely noted that market capitalization weighted portfolios are inefficient and underperform an equal weighted portfolio over the long-term. However, at least since 2016, an equal weighted portfolio of stocks in the S&P500 has significantly underperformed the market capitalization weighted portfolio. In this paper we analyse this underperformance using stochastic portfolio theory. We show that the equal weighted portfolio does appear to outperform the market capitalization weighted portfolio over the long-term but with periods of significant short-term underperformance. We find the concentration in the market capitalization weighted portfolio has increased in recent years and has contributed to the recent underperformance together with a significantly lower level of diversification benefits. Furthermore, we highlight one approach to improving the performance of a portfolio by dynamically selecting a market cap or an equal weighting using a simple linear regression model.
Keywords: Stochastic portfolio theory, equal weight portfolio, portfolio optimization, diversfiication
JEL Classification: G11, G15, G17
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