Equally-weighted indices tell us the performance of the average stock in the selection universe. What return should we expect if we pick stocks randomly (or with a selection rule that is no better than random)? With enough trials and enough time, random selection will produce the return of the average stock in the index. That means that the best estimate of the return of a randomly-selected portfolio is the return of an equal-weight index. Over time, and certainly during the interval covered by the Journal and Vanguard portfolios, equal-weight indices outperformed their cap-weighted counterparts.
The Journal/Vanguard results are not only, and arguably not most importantly, about the perils of relying on backtests. The most important point they illustrate is that equal weighting creates a powerful tailwind for a strategy’s performance. Astute portfolio construction can mask flaws in security selection.
This article was written by Craig Lazarra, global head of index investment strategy, S&P Dow Jones Indices.
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