Why equal-weighted stock-market indexes bounce back faster from bear markets – MarketWatch

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The advantages of indexes that put every stock on an equal footing rather than weighting them by market size haven’t been limited to just superior returns over the long run. They’ve also seen far shorter recoveries from bear markets, analysts note.

From early 1990 until the end of 2016, the compound annual growth rate for the S&P 500 equal-weight index was 11% compared with 9.4% for the more familiar market-cap-weighted S&P 500 SPX, +0.03% said Sam Stovall, chief investment strategist at CFRA, in a Wednesday note.

But during that time, on average, the recovery period from the last three bear markets, which are defined as pullbacks of 20% or more, was three times shorter for the equal-weighted S&P 500 than for the cap-weighted S&P 500, Stovall said.

“So like ripping off a Band-Aid, history suggests, but doesn’t guarantee, that the S&P 500 Equal Weight Index may offer attractive alternatives to its more popular peer when it comes to enduring painful retreats and anxiety-filled recoveries,” said Stovall.

Read: How a more balanced S&P 500 can lead to richer returns

Over the long term, the equal-weighted S&P 500, outperforms the cap-weighted S&P 500, mostly due to its tilt to smaller and value stocks during regular rebalancing.

This makes the equal-weighted index slightly more volatile than the cap-weighted index. For example, the equal-weighted index on average has more pullbacks, corrections and bear markets and the standard deviation of its annual returns is slightly higher.

“Equal-weighting an index is the original smart beta strategy,” said Dana D’Auria, director of research at Symmetry Partners, a Glastonbury, Conn.-based asset manager.

“Because it is rebalanced favoring smaller and value stocks, equal-weighted methodology has higher expected returns and has easier time coming back after corrections,” said D’Auria.

Looking at the historical returns of the Russell 1000 RUI, +0.00% —another popular large-cap index, D’Auria found that the equal-weighted version outperforms the cap-weighted version over the long term.

“From February 1979 to June 2017, the cap-weighted Russell 1000 index returned 11.74% on average. But the equal-weighted Russell 1000 had an annual return of 13.86%. While the equal-weighted index had higher volatility during this time, when adjusted for risk, it was still a better choice,” D’Auria said.

Equal-weighted exchange-traded funds tend to be more expensive than cap-weighted peers, due to higher trading cost associated with regular rebalancing.

Some market participants worry the rally in the S&P 500 over the past few years had been driven by highflying tech stocks dubbed FAANGs—or Facebook Inc. FB, +0.20% Apple Inc. AAPL, +0.47% Amazon.com Inc. AMZN, +1.24% Netflix Inc. NFLX, +1.13%  and Google Inc. GOOG, -0.31% All of these stocks are up between 28%-100% over the past 12 months.

Mitchel Goldberg, president and financial adviser at ClientFirst Strategy, said that an equal-weighted S&P 500 is less risky because it has much lower potential for over-concentration of large momentum stocks.

“Investors in an equal-weighted index would certainly be missing out on glorious returns driven by tech stocks, but this sector is notorious during booms and busts,” Goldberg said. “Investors are taking a lot of risk” with a 25% weighting in of tech stocks, he said.

But the success of the equal-weighted index resides with the ability of investors to hold it for long periods, especially during market meltdowns.

“The real issue is that investors tend to chase different strategies—value, growth, momentum, market weighted, etc. Many strategies work—but over long periods,” said Dina Isola, investment adviser at Ritholtz Wealth Management.

“If an investor finds an investment philosophy that speaks to them, sticking with it vastly improves the chances for success,” Isola said.

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