The Specialness of Equally-Weighted Portfolios: The Rebalancing Fallacy

Abstract

There is overwhelming evidence in equity markets that equally-weighted (𝐸𝑊) portfolios deliver higher average returns and higher Sharpe ratios than value-weighted (𝑉𝑊) portfolios. Rebalancing to fixed weights has typically been advanced as an argument to explain the overperformance of 𝐸𝑊 portfolios. The paper challenges the rebalancing to fixed-weights hypothesis and provides empirical evidence that the overperformance is entirely explained by portfolio volatility and that there is no additional contribution to returns from rebalancing. Conditionally, the long-short 𝐸𝑀𝑉 portfolios, (Equally Minus Value weighted), which are long 𝐸𝑊 portfolios and short 𝑉𝑊 portfolios are shown to overperform only to the extent that they are invested in high variance or in low market capitalization securities. Furthermore, when looking at their dynamics, the overperformance is observed only in a few states of the world. The paper identifies the relevant state variables and documents evidence of predictability using information contained in lagged returns and in lagged volatility. Both variables are found to predict the 𝐸𝑀𝑉 portfolio returns positively. The information is exploited to test simple dynamic strategies which allow the 𝐸𝑀𝑉 portfolio to be held long or short depending on the signals contained in the two conditioning variables. The Sharpe ratios of various long-short dynamic strategies significantly overperform the long-only strategy. When looking at risk-adjusted returns, factor models fail to explain the 𝐸𝑀𝑉 portfolio returns. However, 𝐸𝑀𝑉 portfolios display pricing performance by driving well known factors to statistical insignificance. More generally, the unconditional and the conditional results obtained for the 𝐸𝑀𝑉 portfolios are shown to depend on two cross-sectional correlations, the first between the securities’ active weights and their variances and the second between the securities’ active weights and their growth rates. The cross-sectional correlations are shown to be security and state dependent. The average return on the 𝐸𝑀𝑉portfolio can be positive or negative depending on which one of the two cross-sectional correlations dominates.