Finally, rising dispersion will have some predictable effects on the performance of some factor indices. If winners keep winning and losers keep losing, that’s a recipe for increased dispersion. In such an environment, momentum indices (which buy winners and shun losers) will tend to do well, and equal weight indices (which do the opposite) will tend to underperform. (In July, in fact, the S&P 500 Momentum Index outperformed its equal weight counterpart.) Through July 31, the cap-weighted S&P 500 outperformed equal weight (3.35% vs. 1.69%). Rising dispersion might cause that gap to widen.
An equal weight index measures the return of the average index component. When equal weight is outperforming cap weight (as it typically does), stock picking is relatively easy — in fact a randomly-chosen portfolio should outperform the cap-weighted index. When cap weight outperforms, stock picking is much harder. (Some active managers recoil in horror at the memory of the late 1990s, when the cap-weighted S&P 500 outperformed equal weight for six consecutive years.) If cap weight continues to outperform equal weight, stock selection will continue to be challenged, regardless of dispersion’s level.
This article was written by Craig Lazzara, global head of index investment strategy, S&P Dow Jones Indices.
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