Jul

6

Here is an easy way to check whether equal weight or cap weight index out performs:

Cap-weighted index emphasizes return of large-cap stocks over small, and thus differs from equal-weighted index in which all stocks make equal contribution to index returns. It is well known that small cap stocks have out-performed large-caps in recent years, here shown by regressing weekly returns of Russell 2000 index vs. S&P 500 from 1/01-present:

Regression Analysis: RUT versus S&P 500

The regression equation is
RUT = 0.000274 + 0.920 SP500

Predictor       Coef         SE Coef       T        P
Constant     0.00027    0.00047    0.58   0.563
SP500         0.91963    0.02226  41.32   0.000

S = 0.0151692   R-Sq = 62.3%   R-Sq(adj) = 62.3% 

The small stock advantage becomes very small and insignificant. One conclusion is that small caps may out-perform large caps in some periods, but there does not seem to be a sustained advantage (even including recent out-performance).

Also interesting to consider that (widely used in academic finance) FF regressions have a term for a presumed durable small-stock effect, which in combination with increased popularity of various ETF and equal-weighted index products could help explain recent small-cap strength. 


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