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The fine art of not putting all your eggs in one basket

By: Catherine Yoshimoto, senior index product manager

Surely you've heard the proverb, "Don’t put all your eggs in one basket.” But whether you're talking about indexing or life in general, following that advice isn’t always as simple as it sounds. Many popular market indexes are weighted by the market caps of their constituents, resulting in indexes that predominantly reflect the performance of the few largest companies. An index that equally weights each of its constituents would mitigate this size bias. However, this approach simply moves your eggs into yet another basket – the sectors with the highest number of constituent companies. So how can we neutralize both of these biases to arrive at an index with both sector and company diversification?

FTSE Russell’s solution was to develop a multi-level equal weighting approach with the Russell Equal Weight Index Series, which includes the Russell 1000® Equal Weight Index (R1EW).[1] This approach applies a two-tiered equal weighting methodology – first, to equally weight each sector and then to apply an equal weighting to each constituent within that sector resulting in increased diversification. A secondary result of this methodology is an index that trades in a contrarian nature at quarterly rebalancing time – increasing weights to companies that have recently performed poorly and decreasing weights to those that have performed well.  

To demonstrate how the FTSE Russell equal weighting methodology performed historically compared to a cap-weighted index and a simple equal-weighted index, we created a hypothetical Constituent Equal Weight Index (CEW). Using the down market capture ratio (DMCR) – which measures the percentage of the negative market performance experienced by an index – we compared how the R1EW and the CEW performed against the cap weighted market as a whole as represented by the Russell 1000. A DMCR of less than 100% means that the index had a higher total return relative to the market, and a DMCR of greater than 100% indicates that the index had a lower total return than the market.

Down market capture ratio R1EW and hypothetical CEW Indexes December 2001 – December 2016

Source: FTSE Russell. Data December 31, 2001 through December 31, 2016. Past performance is no guarantee of future performance. Returns shown may reflect hypothetical historical performance. The Russell 1000 constituent equal weight index (CEW) is a hypothetically created index and is not a FTSE Russell index. The data is for illustrative purposes. Please see the end for important legal disclosures.

As we can see in the chart above, the methodology used for the R1EW resulted in lower down market capture and thus higher excess returns over the market than the simpler CEW approach in 14 of the last 16 years. This indicates a lower risk profile for the R1EW index compared to the hypothetical CEW. However, compared to cap-weighted Russell 1000, both equal-weighted indexes exhibited higher volatility due to the heavier weighting to more volatile (and at times higher performing) midcap stocks.

In terms of volatility, R1EW has exhibited the same or lower volatility than the hypothetical CEW over the past 16 years particularly during the turbulent periods of the dotcom bust in 2000- 2002 and the global financial crisis in 2008-2010.[2] As the market entered the dotcom bust, the R1EW had less exposure to the previously booming tech sector and entering the global financial crisis it also had less exposure to the financial sector. 

So how does the historical performance of the R1EW, hypothetical CEW and the Russell 1000 compare? As illustrated in the chart below, over the last 16 years, the R1EW has outperformed the cap-weighted Russell 1000 and the hypothetical CEW.

Cumulative Performance of the R1EW, CEW and Russell 1000

Source: FTSE Russell. Data December 31, 1999 through December 31, 2016. Past performance is no guarantee of future results. Returns shown may reflect hypothetical historical performance. CEW is not a FTSE Russell index. Please see the end for important legal disclosures.

Alternatively weighted indexes have been of increasing interest to market participants over the past several years, and equal weighted indexes were one of the first of these available on the market. Among the benefits of the FTSE Russell approach to an equal weighting methodology is that it reduces the mega cap dominance inherent in cap-weight indexes while also increasing diversification among sectors. In addition, the contrarian trading approach inherent in the FTSE Russell equal weighting methodology is likely to appeal to market participants looking to put their eggs in a number of baskets.

For more detail, please refer to our research, The Russell 1000 Equal Weight Index: Reduced concentration risk and enhanced diversification.

 

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[1] The Russell 1000 Equal Weight Index was launched on October 18, 2010.

[2] Source: FTSE Russell. Data February 29, 2000 through December 31, 2016. Past performance is no guarantee of future performance. Returns shown my reflect hypothetical historical performance. The Russell 1000 constituent equal weight index (CEW) is a hypothetically created index and CEW is not a FTSE Russell index. The data is for illustrative purposes. Please see the end for important legal disclosures.

  

© 2017 London Stock Exchange Group plc and its applicable group undertakings (the “LSE Group”). The LSE Group includes (1) FTSE International Limited (“FTSE”), (2) Frank Russell Company (“Russell”), (3) FTSE TMX Global Debt Capital Markets Inc. and FTSE TMX Global Debt Capital Markets Limited (together, “FTSE TMX”) and (4) MTSNext Limited (“MTSNext”). All rights reserved.

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Past performance is no guarantee of future results. Charts and graphs are provided for illustrative purposes only. Index returns shown may not represent the results of the actual trading of investable assets. Certain returns shown may reflect back-tested performance. All performance presented prior to the index inception date is back-tested performance. Back-tested performance is not actual performance, but is hypothetical. The back-test calculations are based on the same methodology that was in effect when the index was officially launched. However, back- tested data may reflect the application of the index methodology with the benefit of hindsight, and the historic calculations of an index may change from month to month based on revisions to the underlying economic data used in the calculation of the index.

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