I came across an interesting article in the Journal of Asset Management today where a comparison is made between a capitalization weighted (CW) portfolio and an equally weighted (EW) portfolio. In a CW index stocks are weighted for their market capitalization and in an EW index every stock is equally weighted. Most mutual funds use the CW approach for their investment portfolios.
“Figure 1 displays the performance of the DJEURO and the equivalent EW portfolio over the observation period. The cumulative return of the EW portfolio was 38.42 per cent compared with -4.70 per cent of the DJEURO, with a difference equal to 43.12 per cent”
“Figure 2 shows the performance of the DJEURO50 index and its EW version. In this case, the cumulative returns of the EW portfolio and of the DJEURO50 index were 11.60 per cent and -16.63 per cent, respectively, showing a difference equal to 28.23 per cent.”
The reason the EW portfolio does better than the CW portfolio is because of the automatically rebalancing every quarter. The EW portfolio follows a contrarian view in that it sells overvalued stocks each quarter to rebalance the portfolio. The EW portfolio is also more diversified because it has a larger share of mid- and small cap stocks in its portfolio unlike a CW portfolio which exists for a large part out of large cap stocks.