Equal-weighted benchmark portfolios are sometimes overshadowed by the more popular market capitalization benchmarks but are still popular and often used in practice. One of the advantages of equal-weighted portfolios is that academic research shows that in the long term, they tend to outperform their market-cap-weighted peers, mainly due to positive loadings on well-known factor premiums like size and value. So, if equal weighting outperforms market-cap weighting (in the long term), what options do we have if we want to outperform equal weighting? A recent paper by Cirulli and Walker comes to our aid with an interesting proposal …
The authors of this paper challenge the notion that the equally weighted stock portfolio is difficult to outperform. They present a series of simple, non-optimized stock portfolios that are minor modifications to the popular equally weighted strategy but exploit some of the most pronounced stock market anomalies. By screening out stocks with the lowest realized Sharpe ratio and equally weighting the remaining stocks, they provide a simple approximation to a multi-factor portfolio loading on low size, momentum, and low volatility. This simplicity makes the proposed portfolios accessible and easy to implement for the audience.
The resulting portfolios outperform the equally weighted strategy in terms of returns, risk-adjusted returns, and downside-risk measures. Their empirical findings suggest that the equally weighted strategy is less competitive than widely acclaimed and that simple strategies can outperform it in a robust manner. In other words, the equally weighted strategy is not complicated to beat and can be improved significantly through mild adjustments.
For this reason, these newly proposed portfolios can be used as simple additional benchmarks in academic studies and investment decision-making, further raising the bar for optimized or other more complex stock portfolios. As robustness checks, authors also investigate the impact of various levels of proportional transaction costs, the choice of parameters in the portfolio construction, as well as different geographic regions and temporal sub-periods.
Authors: Antonello Cirulli and Patrick S. Walker
Title: Outperforming Equal Weighting
Link: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4669267
Abstract:
The equally-weighted strategy is a popular benchmark in academic studies to evaluate the merit of optimized portfolios or investment strategies. This naive diversification approach has been shown to outperform many more sophisticated portfolios, despite being trivial in the sense that no computations are required, and thus has also caught the interest of practitioners. We demonstrate that the equally-weighted stock portfolio can be consistently enhanced by avoiding negative exposure to some of the most prominent factor anomalies documented in asset pricing literature. Remarkably, this can be achieved while preserving the simplicity of the portfolio construction process. Specifically, we introduce three simple long-only portfolios that rely solely on historical return data. These portfolios exhibit slight deviations from the equally-weighted strategy, yet they consistently generate significantly higher risk-adjusted returns in realistic out-of-sample assessments. Consequently, our research offers the most straightforward illustrations to challenge the prevailing notion that outperforming the equally-weighted strategy is difficult. Moreover, these findings carry implications for the selection of benchmarks in both academic studies and practical investment management. Highlights: • We present simple enhancements to the equally weighted strategy, based on the most pronounced asset pricing anomalies, in order to improve both risk and return. • We consider highly liquid stocks and provide robustness checks on transaction costs, parameter choices, geographic regions and subperiods. • We propose to employ the newly suggested strategies as additional benchmarks in academic studies and practical investment strategy backtesting.
As always we present several exciting figures and tables:
Notable quotations from the academic research paper:
“In summary, our proposed approach involves the screening of stocks with the lowest historical returns and the highest volatility, effectively excluding them from the investment universe. Subsequently, we advocate for equal-weighting the remaining stocks within a frequent rebalancing framework. This strategy offers a straightforward, albeit rudimentary, approximation of a multifactor portfolio, with exposures to factors such as low size, short-term reversal, momentum, and low volatility. Remarkably, this simplified approach consistently outperforms both the equally-weighted and capitalization-weighted benchmarks. Importantly, these superior results are not driven by exposure to small- and micro-cap stocks due to the universes of large-cap companies considered in our analysis.
The momentum enhanced equally weighted strategy removes the weakest past performers from the portfolio and equally weights the remaining stocks. The results for the All Country universe, which is defined the union of Developed and Emerging Markets, are illustrated in the top panel of Figure 1. The risk-return profiles of the momentum enhanced strategies are superior to the equally and the capitalization weighted benchmarks as they move to the top left of the risk-return plot. It should be noted that while the turnover increases with stricter exclusion of past losers, the net returns are still monotonically increased when excluding more weak momentum stocks. Our assumption of 10 basis points fees is realistic or even conservative for the stocks investigated herein. Historical implementation costs of real-world momentum strategies on liquid large-cap stocks have been shown to be in that range or lower (Israel et al., 2021). Other performance metrics, along with the results for several geographic sub-regions (Europe, USA, Emerging Markets and Developed Markets) are reported in Table 1. We find consistent improvements of the momentum enhanced strategies across all geographic markets. In most cases, removing more past losers generates higher returns. The largest effect is achieved in the European market. In addition, a systematic reduction of portfolio volatility and maximum drawdown is attained through removal of weak momentum stocks. Hence, the momentum enhanced strategies results in higher risk-adjusted returns (Sharpe ratio) in all universes and at all thresholds analyzed herein.
The third type of enhancement to the equally weighted portfolio combines the momentum and the volatility information used previously by filtering out the stocks with the weakest risk-adjusted performance, as measured by the Sharpe ratio estimated over a lookback period of five years. Using this long-term estimate reduces the turnover substantially and makes the strategy very robust to transaction fees. In line with the above results, virtually all measures of return and risk improve monotonically when more and more stocks with low past Sharpe ratios get excluded. The improvement in risk-adjusted return of the enhanced over the naive diversification strategy ranges from 19% in emerging markets to 51% in Europe. Moreover, all versions of our proposed enhancement beat the plain equally weighted strategy and the capitalization weighted market index. This points out the blatant inefficiency of both benchmarks, even after accounting for transaction costs of the more active strategies, as visualized in the bottom panel of Figure 1.
Subperiod Analysis
All results reported in the main part above are average statistics over the sample period that spans more than twenty years of data. In theory, the entire outperformance of our proposed enhancements of the equally weighted strategy could stem from a particular period in time, such as the global financial crisis 2008-2009. Similarly, the excess returns could flatten out over time and would thus not be relevant for future investment decisions. For this purpose, we analyze rolling three year Sharpe ratios, enabling us to compare the risk-adjusted returns of the different strategies across time. We report the results for the MSCI All Country universe in Figure 2, while the findings are highly similar across other geographic regions. Notably, the equally weighted portfolio is below the enhanced portfolios almost all the time. For the momentum enhancement (top panel), some short periods of outperformance of the basic naiver diversification portfolio are in early 2006 and in 2019. For the Sharpe Ratio enhanced portfolio (bottom panel), clearly the most robust improvement of those suggested, the equally weighted portfolio never outperforms the competitors in risk-adjusted terms over a three year period, except for a brief period in 2021. These findings provide evidence that our simple factor-based enhancements of the equally weighted portfolio reliably generate higher risk-adjusted returns over a medium-term investment horizon.”
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