Historical data makes a compelling case for the equal weight advantage, but cap weight has been trouncing equal weight since RSP and QQQE's ... over 6 years ago.

Yes, it has been a good time for giants.

There are two main explanations that spring to mind.

One is that it has been a bull market for them recently, and they're new overvalued relative to their somewhat smaller brethren, which is likely to be followed by mean reversion. Not necessarily that the giants will do badly, but that leadership will be outside the top handfull. The rhyme from history: cap weight had another stretch of great results not that long ago, and it ended. The real total return of the S&P 500 in the 5- and 6-year stretches to the March 2000 peak, dominated by the largest firms, were 22.8%/year and 19.7%/year. The next 5 and 6 years were -3.7%/year and -2.3%/year: what goes up [too much] must come down. Equal weight relative to cap weight in the 5 years before the peak: lagging by -8.6%/year, same mood as now. In the five years after: equal weight advantage 11.0%/year.

Another explanation is that it is different this time, and the very biggest will remain the best investments going forward even from these levels. That "different this time" phrase isn't tongue in cheek, there are real reasons to consider that. Very small listed firms are terrible businesses now unlike the past, since decent ones are simply acquired so there is no pipeline of new winners. Almost every US industry is seeing reduced competition and consequently higher rewards to the biggest. There is no prospect of government fiscal retrenchment, and from the macro identities high corporate profits are the most prominent flip side of government deficits. Regulatory capture is always a problem, but probably an even bigger problem with such size concentration.


Nobody has ever said that equal weight will beat cap weight all the time. But for someone without better information, being the audience for index funds, it's the smart bet. I have cap weight and equal weight real total return data daily back to 1930, and equal weight wins most of the time (after backfilling with the modern era cost drag of trading and fees). As others noted, historically the outperformance is particularly strong on average after a stretch that cap weight has been in the lead for a long while. That may not be the case this time, but it's a bit of a bonus reasoning to add to the long run smart bet.

On an entirely unrelated subject, I note that the ETF HDGE, currently trading at $15.93, has returned -7.6%/year in the last 5 years. This is quite good performance for a short fund in a stretch that SPY has returned +14.5%/year. Somebody with no idea of market direction who put half their money into each of them (direction neutral on starting day) five years ago then took a nap would have made 5.7%/year. (admittedly far from fully hedged in the latter part: 50% net long by now)

Jim