By: Catherine Yoshimoto, Senior Index Product Manager
The "Keep It Simple & Straightforward" (KISS) principle states that most systems work best if they are kept simple rather than made complicated. While KISS has its origins in aircraft engineering, the concept can also be applied to indexing. What could be simpler than constructing an index by applying equal weights to each sector? And what effect would this re-weighting of the index have on its performance compared with its more traditional market-cap weighted counterpart? Let’s put KISS to the test.
First, why equal-weighting? Index construction using market-cap weights often leads to concentrations in single stocks or sectors. In addition to simplifying the method, equal-weighting an index would remove these concentration risks—thereby increasing diversification. As a result of this diversification, if larger companies are performing poorly and if smaller companies are performing relatively well, for example, the equally-weighted index would likely outperform the market cap weighted index. Regular rebalancing also keeps constituent valuations in check.
FTSE Russell has several equally weighted indexes that are constructed based on market-cap weighted reference indexes. In this analysis I have chosen to compare the large-cap Russell 1000® with its equal-weighted counterpart (EW). As depicted below, the Russell 1000 EW Index has performed higher than its market cap weighted counterpart by 336 basis points year-to-date through October 31. We can uncover the source of this difference in performance by first looking at a comparison of the sector weightings in each index.
The Russell 1000 EW Index methodology gives equal weight to each sector and then to each security within each sector. By equal-weighting at the sector level first, there is an additional layer of diversification. As illustrated below, the Russell 1000 EW Index avoids the sector concentration inherent in the market cap weighted Russell 1000 methodology.
Equal-weighting can have a significant effect on index performance. We can see, based on the performance chart below, how the Russell 1000 Index sectors fared and contributed to the performance of the EW index. When analyzed in the context of the average sector weighting differences for the year, the Materials & Processing, Utilities and Energy sectors were relatively overweight in the EW index. These three sectors performed well in 2016, thus boosting performance for the EW Index from a sector perspective. Health Care was underweight in the EW Index which also helped its performance due to the sector’s negative performance in 2016 so far.
As we have seen, sometimes there is beauty in simplicity. Under the right set of circumstances, the KISS principle may prove beneficial if you are seeking a diversified index.
Please refer to the FTSE Russell website for more on the Russell Equal Weight Indexes Methodology.
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