SPIVA Award to paper on equal weighted portfolios

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Raman Uppal,Grigory Vilkov and Yuliya Plyakha have claimed first prize at the SPIVA Awards for the paper "Why Does an Equal-Weighted Portfolio Outperform Value- and Price-Weighted Portfolios?"

 

The authors use the non-parametric monotonicity tests developed in Patton and Timmermann (2010) to study if there is a relation between a particular characteristic of stocks and the total return of the equal-weighted portfolio relative to the value- and price-weighted portfolios.

These tests indicate the returns of the equal-weighted portfolios relative to the returns of the value- and price-weighted portfolios are monotonically decreasing with size and price, and monotonically increasing with idiosyncratic volatility. Liquidity is monotonically related to the difference in returns of the equal- and value-weighted portfolios, while book-to-market is related to the difference in returns of the equal- and price-weighted portfolios.

Reversal and three-month momentum are not significantly monotonically related to the returns of the equal-weighted portfolio relative to the value- and price-weighted portfolios, although it is the stocks with extremely low and extremely high reversal that contribute to the higher alpha of the equal-weighted portfolio.

The authors used a standard fourfactor model (Fama and French (1993) and Carhart (1997)) to decompose the total returns of the equal-, value-, and price-weighted portfolios into a systematic component which is related to factor exposure, and alpha, which is not related to factor exposure.

The found that of the total excess mean return of 271 basis points per annum earned by the equal-weighted portfolio over the value-weighted portfolio, 42% comes from the difference in alpha and 58% from the excess systematic component.

Of the total excess mean return of 112 basis points earned by the equal-weighted portfolio relative to the price-weighted portfolio, 96% comes from the difference in alpha and only 4% from the difference in systematic return. The proportional split between systematic return and alpha is also similar after adjusting for transactions costs of 50 basis points.

The higher systematic return of the equal-weighted portfolio appear to arise from its higher exposure to the market, size, and value factors. However, the equal-weighted portfolio has a more negative exposure to the momentum factor than the value- and price-weighted portfolios.

The two experiments show that the higher alpha and less negative skewness of the equal-weighted portfolio are a consequence entirely of the monthly rebalancing to maintain equal weights, implicitly a contrarian strategy that exploits the reversal in stock prices at the monthly frequency.

In the first experiment, the rebalancing frequency of the equal-weighted portfolio is reduced. As the rebalancing frequency decreases from one month to six months, the excess alpha earned by the equal-weighted portfolio decreases, and the skewness of the portfolio return becomes more negative.

When the rebalancing frequency is further reduced to 12 months, the alpha of the equal-weighted strategy is indistinguishable from that of the value- and price-weighted strategies.

In the second experiment, the weights of the value- and price-weighted portfolios are fixed so they have the contrarian flavour of the equal-weighted portfolio. We find this increases their alpha and makes skewness less negative. If the weights of the value- and price-weighted strategies are fixed for 12 months, the alpha of these portfolios increases and is indistinguishable from that of the equal-weighted portfolio.

An important insight from these two experiments is that it is not the initial weights of the equal-weighted portfolio, but the rebalancing policy that is responsible for the alpha it earns, relative to the alphas for the value- and price-weighted portfolios.

 

To read the full study report click here: EDHEC Working Paper: Equal Weighted Portfolio

 

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