Why Do Equal-Weighted Portfolios Outperform Value-Weighted Portfolios?

Abstract

We compare the performance of equal-, value-, and price-weighted portfolios of stocks in the major U.S. equity indices over the last four decades. We nd that the equal-weighted portfolio with monthly rebalancing outperforms the value- and price-weighted portfolios in terms of total mean return, four factor alpha, Sharpe ratio, and certainty-equivalent return, even though the equal-weighted portfolio has greater portfolio risk. The total return of the equal-weighted portfolio exceeds that of the value- and price-weighted because the equal-weighted portfolio has both a higher return for bearing systematic risk and a higher alpha when using the fourfactor model. The nonparametric test of Patton and Timmermann (2009) indicates that the dierences in the total return of the equal-weighted portfolio and the valueand price-weighted portfolios is monotonically related to size, price, liquidity and idiosyncratic volatility; the relation with reversal is not monotonic, although the equal-weighted portfolio strongly outperforms the value- and price-weighted portfolios for the deciles with the lowest and the highest reversal characteristic. The higher systematic return of the equal-weighted portfolio arises from its higher exposure to the market, size, and value factors. The higher alpha of the equal-weighted portfolio arises from the monthly rebalancing required to maintain equal weights, which is implicitly a contrarian strategy that exploits reversal; thus, alpha depends only on the rebalancing frequency and not on the choice of initial weights.