Mindful investing involves buying a moderately diversified set of low-cost stock index funds and holding them for the long term.  This one sentence is a decent summary of the entire Mindfully Investing website.  And yet our emotions and other distractions can make this simple-sounding plan hard to consistently execute over many years.  This is where the practice of mindfulness can mean the difference between investing success and failure.

Mindful investing also requires awareness of some details and an understanding of when those details might impact your investing goals.  That’s the reason that Mindfully Investing has nearly a 100 posts and articles to date about such a simple-sounding investing method.

What Is Weighting?

One detail that I haven’t yet addressed is the variety of stock weighting approaches used in relatively low-cost index funds.  Weighting is the proportion of the fund’s value that’s assigned to any given company stock from an index.  The most common weighting methods are:

• Price weighting – The proportions of various stocks is determined by stock price.  A price-weighted fund tracking an index of two stocks, with the “Solo Company” at $100 per share and “Duo, Inc” at $50 per share, would hold twice as much of Solo stock as Duo stock.  Funds that track the Dow indices are good examples of price weighting.
• Market-capitalization (cap) weighting – This is by far the most common method, which uses market cap to determine the proportions of each stock in the fund.  Market cap is the overall value of a company’s stock as determined by the price multiplied by the total number of shares outstanding.  Well known companies that we tend to think of as “big” (like Apple, Coke, or GE) have large market caps.
• Fundamental weighting – This method assigns proportions using metrics like sales, book value, dividends, cash flow, earnings, or some other measure of a company’s value.  A whole universe of specific metrics and methods exist within this category.
• Equal weighting – If an index contains 10 stocks, the equal-weight tracking fund would have 10% of its value in each stock, regardless of price, size, or any other characteristic of those companies.  All stocks are treated “equally”.

Everybody Likes Equality

Although the concept has been around since at least the 1970s, equal-weight index funds have really taken off in the last 10 to 15 years.  Whether it’s the cause or effect, I’m not sure, but equal weighting is getting increasing media attention and has almost become a fad.  Buying and holding a moderately diversified set of low-cost equal-weight index funds ostensibly meets the requirements of mindful investing.  Let’s find out whether equal weighting is a more mindful choice than the more traditional market-cap-weighted index funds.

The most common claim you’ll find about equal-weighted index funds is that they tend to out perform similar market-cap-weighted index funds.  A chart like this from Portfolio Visualizer is often presented to “prove” the point.

The chart compares two S&P 500 index funds, one equal weighted (ticker symbol RSP in blue), and the other traditionally market-cap weighted (ticker symbol SPY in red).  While the graph looks compelling, one of the key tenants of mindful investing is to be super skeptical of any claim of “beating the market”.  Equal weighting smells like a beat-the-market scheme, but is it really?  After all, both funds in the above example are tracking the same 500 large U.S. companies, but in different ways.  Perhaps equal weighting is just capturing the market return in a more efficient way than market-cap weighting.

A Closer Look

Of course, I couldn’t resist dismantling this problem and examining all the moving parts in more detail.  Accordingly, I gathered a list of some of the most popular equal-weight funds available and compared them to similar market-cap-weighted funds tracking the same or very similar indices.

I thought it was important to use actual funds, not data from the indices themselves, because funds are the only way most of us can invest in an index.  Using fund data is more realistic, because funds charge fees, don’t necessarily track the indices perfectly, and have other implementation artifacts.  One drawback of using fund data is that equal-weight funds have only been around for about 5 to 15 years.  We should keep this short track record in mind while making these comparisons.  Here’s a list of the indices and funds I used for the comparison, including the fund inception dates and annual expense ratios.

Index Tracked	Equal-Weight Fund	Inception Year	Expense		Market-Cap Weight Fund	Inception Year	Expense
S&P 500 Large Cap	RSP	2003	0.20%		SPY	1993	0.04%
S&P 400 Mid-Cap	EWMC	2010	0.40%		IVOO	2010	0.15%
S&P 600 Small Cap	EWSC	2010	0.40%		VIOO	2010	0.15%
Emerging Markets	EWEM	2010	0.70%		VWO	2005	0.14%
Russell 1000 – “Mid-cap”	EQAL	2014	0.20%		VONE	2010	0.12%

Note that EWEM was originally an equal-weight fund, but in 2015 it moved to equal weight by country.  (This means that the value of EWEM holdings from each country is about the same, but the stocks from each country are market-cap weighted, so it’s a bit of a hybrid.)  Also, the Russell 1000 contains the largest 1000 U.S. companies that make up about 90% of the total U.S. market capitalization.  I labeled this as another “mid-cap” index because the average company size is smaller than the S&P 500.

Returns Comparison – This graph immediately shows that the claim of better returns for equal weighting only materialized in one of the five comparisons.

The large cap equal-weighted fund outperformed its market-cap counterpart, but the opposite is true of the mid, small, emerging stock comparisons.

Risk-Adjusted Returns Comparison – Another claim is that equal-weighted indices don’t necessarily offer better total returns, but they instead provide better risk-adjusted returns, where routine volatility is the proxy for “risk”.  As a measure of risk-adjusted returns, let’s look at the ratio of return over risk for these same funds.  You can think of this ratio as the percent of returns received for each percentage of routine volatility (standard deviation) experienced.  The higher the ratio, the better.

In risk-adjusted terms, equal weighting performs even worse, at least using these examples.  Even for the large cap comparison, the extra returns for the equal-weight fund don’t fully counterbalance the extra volatility experienced.

Using the classic scatter plot of returns versus risk, we can see the relationship between the two metrics more easily.

Theoretically, the blue equal-weight funds should be above and to the right of the orange market-cap funds.  Moving towards the upper right represents higher returns, but with higher volatility.  In fact, except for the large cap comparison, the green arrows show the direction is down and to the right, which means equal weighting is providing lower returns AND more volatility.  Not good!

Cost Comparison – It’s also often noted that equal-weight fund costs are generally higher than market-cap fund costs as the above table shows.  There’s no point in paying higher costs for lower returns, so there’s very little reason to use equal-weight funds for small, mid-cap, and emerging markets.  However, I was curious to see whether the extra expense of equal weighting nullified the slightly better annual returns for the large cap fund.  I calculated the after-cost returns of an initial one-time $10,000 investment in RSP (equal weight) and SPY (market cap) over 30 years using two methods:

1. Constant annual returns using the historical annualized return to date
2. The sequence of returns for the last 15 years and then repeating that sequence for the second half of the 30 year projection.

Method	RSP (Equal) Final Value	SPY (Market-Cap) Final Value	Difference in Final Value	RSP Additional Cost
1. Annualized	$139,410	$110,271	$29,138	$473
2. Sequenced	$122,668	$99,006	$23,662	$400

Over a long-term investing horizon, the extra cost of an equal-weighted large cap fund is pretty small in comparison to the higher cumulative returns, even for a relatively modest initial investment of $10,000.

Returns Over Time – Perhaps with a longer track record, equal weighting might better outperform market-cap weighting in all these comparisons.  For example, the blogger Lyn Alden conducted an interesting comparison using the broad Wiltshire 5000 indices (not funds) going back to 1970 that showed a pretty clear benefit to equal-weighting over this much longer time frame.

Noting the limitations of a 15 year time frame, here’s a graph of RSP versus SPY in the style that John Bogle calls the “Telltale Chart”.  It plots the ratio of the cumulative returns of the two S&P 500 funds.

When the line is rising, it means that equal weighting (RSP) is outperforming market-cap weighting (SPY).  When the line is falling, as shown by the green shading, it means market cap is outperforming equal weight.  For example, if you had invested $10,000 in both funds in 2003, five years later both funds would have lost you money, but the market-cap fund would have about $270 more.  Market-cap weighting also performed slightly better for 4 years from 2014 to 2018.

Even this relatively brief example illustrates that the superior returns of large cap equal weighting will ebb and flow over time.  In the future you might have to wait even longer than 4 or 5 years to see superior cumulative returns using an equal-weighted large cap index fund.  Or that fund might consistently out perform for the next 10 years.  There’s essentially no way to be sure in advance.

Why Is Equal Weighting So Sporadic?

Despite claims that equal weighting is superior, recent history shows it actually under performed market-cap weighting in the small, mid-cap, and emerging market arenas.  And even for the large cap comparison, equal weighting provided superior returns in some years but not in others.  What’s causing these sporadic results?

Larry Swedroe provides a compelling explanation for why equal weighting works best for large cap indices.  He explains that, by definition, equal weighting tilts the fund away from the largest capitalization companies and more towards smaller capitalization companies.  Smaller size is one of the classic investing “factors” that have historically generated a returns premium.  The market-cap weighted mid-cap, small cap, and emerging market indices already have high representation from smaller companies.  So, when equal weighting replaces cap weighting in these funds of smaller companies, the weights actually shift much less.  Swedroe concludes that equal weighting is just a different way of exploiting the historically higher returns (and higher volatility) of small company stocks.  A recent Dow Jones report echos this finding and explores some additional factors and causes behind the large cap equal-weight premium.

Although less obvious, it’s also generally true that equal weighting tilts a fund toward value companies and away from growth companies.  Value is probably the second most commonly cited investment “factor” that has historically generated a return premium.  Equal weighting may cause a shift toward value because the largest cap companies are closely watched and are more likely to be priced to perfection, while many less well known mid-sized and small companies often have better but overlooked value metrics.  Swedroe presents some calculations using Portfolio Visualizer’s factor regression calculator showing how several equal-weight funds achieve higher returns (sometimes) specifically because they tilt the fund towards both the small size and value factors.

None of that explains the see-saw performance over time of equal versus cap weighting.  This back and forth is very similar to the track record of even the most robust of the historical investing factors.  For example, there have been many past periods when large cap stocks out performed or kept pace with small cap stocks, as shown in this telltale chart from Wisdom Tree.

This graph ends in 2012 with small caps having been on top for 13 years.  But Portfolio Visualizer indicates that small caps subsequently under performed large caps from 2012 to 2018, with small caps generating an annualized return in those 6 years of 14.3% versus 14.8% for large caps.  The erratic performance of equal weighting is not the exception, but follows a rule that applies to almost any attempt to boost stock returns.

Conclusion

The bottom line is that you can achieve the somewhat higher returns of an equal-weighted large-cap fund, by simply allocating some of your portfolio to mid-sized or small market-cap weighted index funds.  And by sticking to market-cap weighted funds, you have access to the desired return premium at a lower cost.  Lawrence Hamtil recently posted a similar observation, including this performance chart comparing three indices:

• Equal-weighted S&P 500 index
• Market-cap weighted mid-cap S&P 400 index
• Market-cap weighted S&P 500 index.

There’s a remarkable congruence between the standard mid-cap index and an equal-weighted S&P 500 index.  So, its clear you can get almost all the benefits of equal weighting without the additional costs.

Now whether and how much you should actually allocate some of your portfolio to small or mid-cap index funds is another question entirely.  That question gets into the world of factor investing, which is something I’ve only talked briefly about to date.  I can’t say when exactly, but I plan to make some forays into the world of factor investing in the future.