One of the most common questions in the

comments on this channel is what about

equal weight index funds or some version

of that question. I promise you equal

weight index funds are not that

exciting. But people keep asking me the

question. So here we are. Market

capitalization waiting, which is what

typical index funds do, assign index

weights based on each company's size. An

equal weighted index fund, as the name

implies, equally weights all of the

stocks in a market or market segment.

Equal waiting seems like the solution to

many of the perceived problems that

market capitalization weighted indexes

have today, like high valuations and

high levels of concentration in the top

stocks. Equal weighting has actually

outperformed cap weighting going back

decades as well. But it introduces its

own unique risks, costs, and

inefficiencies. I'm Ben Felix, chief

investment officer at PWL Capital, and

I'm going to tell you why I do not use

equal weighted index funds.

Equal

weight index funds do look really

compelling right now. They don't have

the same level of concentration as a

market cap weighted index fund and they

have a long track record of strong

performance even in live fund data

reflective of real fees and costs. The

Invesco S&P 500 equal weight ETF has

outperformed the S&P 500 for most of its

life since 2003 and for the full period

since its inception in 2003. Just by a

hair though. But before getting too

excited, it's important to understand

the trade-offs and to give some context

to the past performance. I'm also going

to show you why I think the benefits of

equal weighting can be achieved more

efficiently without its associated

drawbacks. Let's start with some quick

background on equal weighted versus

market capitalization weighted indexes.

When you create a stock index, one of

the most fundamental questions that you

have to answer is how you're going to

weight the stocks in your index. Market

capitalization waiting means holding

stocks at their market capitalization

weights. Market capitalization is just

what the entire company is worth on the

stock market, like how much it would

cost to buy every single share of Apple

or Shopify. A larger company will make

up a larger portion of a market

capitalization weighted index than a

smaller company. Makes sense. Equal

weighting, on the other hand, assigns

equal weights to stocks regardless of

their market capitalization. These

approaches can result in significantly

different portfolios given the same set

of stocks. The logic of market

capitalization or market cap waiting is

pretty simple. The market has determined

how much weight each stock should have.

This is why market cap index investing

is often referred to as passive. You're

passively allowing the market to

determine the weights of the stocks that

you own. It's like letting water find

its own level instead of constantly

trying to adjust it yourself. The nice

thing about this is that it does not

require you to make decisions about how

to weight the stocks in your index. The

weights just are. Another benefit is

that because the index represents the

market, it doesn't need to be rebalanced

frequently. As stock prices evolve, the

market capitalization weighted index

fund evolves in exactly the same way as

the market without needing you to make

trades. One of the perceived problems

with market cap waiting is that it can

result in high weights in a relatively

small number of stocks. Something we are

seeing an extreme version of in the US

market, at least relative to its own

history right now. This index

concentration kind of es and flows

naturally over time as some businesses

become increasingly successful and earn

a larger share of the market. Market

concentration can seem concerning, but

the historical relationship between

market concentration and future market

returns has not been strong historically

in the US or in other countries around

the world. If we sort 10-year future US

stock market returns on their starting

level of market concentration, there's

really not much of a relationship there.

Many other countries have been and are

today more concentrated in the top

stocks in the index than the US market

is even today when it's more

concentrated than it has been in the

past. In any case, index concentration

is a current concern for many investors.

An equal weighted index by construction

by design won't ever be concentrated in

a small number of stocks in the same way

that a market capitalization weighted

index can be. But it will result in

significant under and overweights of

stocks relative to their market

capitalization weights. Now this is an

interesting question whether having a

high weight in large companies in a

market cap weighted portfolio is riskier

than having large overweights to smaller

companies and underweights to larger

companies in an equal weighted

portfolio. The answer is not black and

white but I think there's a legitimate

argument that the extreme over and

underweing in an equal weighted

portfolio is actually riskier than

accepting concentration in larger

companies in a cap weighted portfolio.

This risk can show up in a couple of

different ways. One is in volatility.

Looking at an ETF tracking the S&P 500

and one tracking the S&P 500 equal

weight, the 15-year standard deviation,

a measure of how much variability there

is in index returns, is quite a bit

higher for the equal weight index than

for the market cap weighted index.

Volatility is not the only way to think

about risk. Another way to measure risk

is by exposure to certain types of

stocks that tend to move together. Some

stocks like small cap and value stocks

are theoretically priced as being

riskier by the market. And an equal

weight index has more exposure to these

types of stocks than a market cap

weighted one simply because smaller and

cheaper stocks make up a smaller portion

of the market. Equal weighting all

stocks results in a natural tilt towards

smaller and lowerpriced stocks. This

speaks to one of the other perceived

benefits of equal weighting in the

current market environment. Stock

valuations in the US market are high

relative to their own history. High

current valuations do have a

relationship with lower future returns.

They're not perfectly predictive, but

there's something there. Due to its

natural tilt away from the largest and

highest price stocks, an equal weighted

index will have a lower aggregate

valuation than a market cap weighted

index. We can see this now with the

price to earnings and price to book

ratios for an equal weighted S&P 500

fund being much lower than those for a

market cap weighted fund. Those

exposures to smaller and cheaper stocks

are not a bad thing. I would actually

argue that they're a good thing when

they're done right. The problem is that

if you want to have exposure to these

types of stocks, they're probably more

efficient ways to get it. I'll explain

that in a minute. Equal weighted indexes

will also tend to have materially

different sector exposures compared to

market capitalization weighted indexes.

Sector over or underweights introduce a

whole other type of risk that most

investors probably want to avoid. Again,

looking at the pair of S&P 500 ETFs as

an example, we can see the sector

compositions are materially different

with a large underweight to technology

and overweight to industrials for the

equal weight index. If you want those

over and underweights because you have a

view on how those sectors are going to

perform in the future, I I guess that's

fine. But sector bets tend to be really

hard to get right. A lesser known issue

with equal weights is the implications

for rebalancing. One issue is more

frequent rebalancing. When a smaller

company gets larger, a market cap

weighted index does not need to do

anything. But an equal weight index

likely needs to sell down the position

back to equalize weights at its next

rebalancing. The same thing happens when

a large company gets smaller. For

example, this S&P 500 equal weight index

ETF has had average annual turnover more

than 10 times higher than a market cap

weighted S&P 500 ETF. Turnover comes

with implicit and explicit trading costs

that are ultimately borne by the fund

investors. The other rebalancing issue

is that equal waiting is naturally a

negative momentum strategy. This is a

big deal. I I'll explain what it means.

Momentum is the extremely well doumented

phenomenon first identified by Jagadish

and Titman in their landmark 1993 study

that stocks that have recently done well

tend to continue to do well for a time

and those that have recently done poorly

tend to continue doing poorly for a

time. Equal weight funds to maintain

their equal weights are always going to

be selling what has done well recently

and buying what has done poorly. If a

stock does well and gets bigger, its

weight will exceed its equal weight

target. And a stock that does poorly

will fall below its target. Maintaining

equal weights then means systematically

trading against momentum. We can show

this with a multiffactor regression.

That's a statistical test that shows us

what's driving a fund's returns. It's

kind of like a like a blood test for a

fund. It tells you what's in your

system. Looking again at the equal

weight S&P 500, we can see that it loads

positively on the size factor and the

value factor and loads negatively on the

momentum factor. These factor loadings

are all statistically significant,

meaning they're real patterns, not just

noise in the data. This means that this

fund has more exposure to small cap and

value stocks than the market cap

weighted total market index and that

it's trading in the opposite direction

of momentum. This is exactly what you

would expect based on the equal weighted

index's structure. It's naturally

overweight, smaller and cheaper stocks

and underweight larger and more

expensive stocks. and it trades against

momentum systematically by the way that

it's designed. Now, here's the big

question. If you want exposure to

smaller and lower priced stocks, is

equal weighting the most efficient way

to get there? There are other investment

strategies that look a lot like index

funds, but don't strictly follow market

cap weights. For example, the

dimensional US core equity one fund has

roughly similar exposures to the small

cap and value factors as the equal

weight S&P 500 ETF. But rather than

naively getting to these exposures

through equal weighting, Dimensional is

being super intentional about targeting

certain types of stocks. This

Dimensional Fund has a net expense ratio

of 15 basis points, 0.15%, compared to

the equal weight S&P 500 ETFs, 0.2%.

It's basically a wash on fees with a

slight edge for dimensional. I'm going

to talk about the long-term data for

this mutual fund which is the the one

I'm talking about is a mutual fund. That

fund is only available through financial

advisors. That's just how Dimensional

distributes their products. But just to

make sure that this is relevant for

people watching, the same strategy is

available now through a US listed ETF

that anybody can buy. There's no no

restrictions. Uh so Dimensional's

intentional approach shows up in a

couple of different ways. One is that

they limit the sector divergence from

the market by placing a cap on sector

weight differences to avoid taking on

large sector bets. Another intentional

difference is in their treatment of

momentum. So remember equal waiting is

short momentum. It's taking it's got

negative momentum exposure. Dimensional

applies a rule when they trade to avoid

selling recent winners and avoid buying

recent losers all else equal.

Dimensional funds are not index funds.

So they have the ability to do that type

of flexible trading. They can decide to

buy this stock instead of that stock.

Though they'll buy the one that does not

have the the negative momentum exposure.

Another important way that their

intentional implementation shows up is

in the way that the portfolio turns

over. How how frequently the holdings

change. So, it's got similar tilts

towards smaller and lower price stocks

to the equal weighted S&P 500 fund, but

the Dimensional Fund has a really modest

turnover. Now, a big part of the reason

is that while Dimensional is tilting

towards smaller and lower price stocks

very intentionally, they use market cap

weights as a starting point. So they

start with take the market portfolio

take like a market cap weighted index

fund and then they're applying modest

tilts to get the exposures that they

want to smaller lowerpriced more

profitable companies. So this starting

with market cap weights minimizes

unnecessary deviations from market cap

weights which then translates to less

aggressive rebalancing requirements. You

don't have those extreme movements like

you have in a in an equal weighted fund.

on the concentration concern by tilting

away from larger and higher price

stocks. The dimensional fund is reducing

concentration but not to the same extent

as equal waiting. If your only concern

is market concentration, equal waiting

is a is a really good solution, but

that's probably not the right problem to

to solve. Looking again at factor

regressions, we see that the dimensional

fund and the equal weight S&P 500 fund

have had roughly similar factor

exposures. But as expected, the

Dimensional Fund is not taking a

negative position on momentum because of

the way that they trade. Going back to

2005 when the Dimensional Core Equity

One Fund first launched, both the equal

weight S&P 500 ETF and the Dimensional

Fund trail an S&P 500 ETF, but the

Dimensional Fund does outperform the

equal weight fund. This was a period

where large stocks with high prices

performed really well. So the result of

the S&P 500 coming out ahead over this

period is not surprising. Going back to

1971,

which is when back test data start for

the S&P 500 equal weight index, equal

weighting looks really, really good

compared to the market cap weighted S&P

500. This was a period where small cap

and value stocks performed well. Again,

we can see using multiffactor regression

that the performance of the equal

weighted fund is largely explained by

higher exposure to small cap and value

stocks with a negative contribution from

momentum. Comparing this equal weight

result to the backtested dimensional US

core equity 1 index. So to be clear,

this is not a fund anymore. This is a

back tested index is is also a really

interesting comparison. It had roughly

similar exposure to small cap and value

stocks, a lighter negative exposure to

momentum, and it performs nearly

identically to the equal weight S&P 500

index over the full period with less

volatility. Keep in mind that for both

of these back tested examples that this

is back test data, which can be pretty

unreliable. There's a saying in finance

that you'll never see a back test you

don't like. They're built with the

benefit of hindsight and they don't

reflect real world implementation costs.

But it's still interesting to see a

similar trend to what we saw in live

funds. Exposure to smaller and cheaper

stocks and negative exposure to momentum

in the case of the equal weight fund

explains most of the results. Equal

weight indexing seems appealing right

now because high concentration in the

top stocks and high market valuations in

the US market are making investors

nervous. That in addition to some pretty

attractive long-term back tests seem to

make a strong case for equal waiting.

But it comes with some baggage. Equal

waiting results in large over and

underweights at the individual stock and

sector levels, high portfolio turnover,

and a systematic bet against momentum.

The strong past returns of equal

weighting are largely explained by tilts

towards smaller and lowerpriced stocks

rather than some magic from equal

weights. The implication for investors

is that if you want to tilt towards

smaller and lowerpriced stocks, which is

a reasonable thing to want to do, you

can do it without introducing all of the

downsides of equal waiting. Dimensional

fund advisors creates products that do

something like that. They tilt towards

smaller and lower price stocks

systematically in addition to a couple

of other factors while controlling for

sector exposure, limiting portfolio

turnover, and intentionally avoiding

trading against momentum among a whole

bunch of other interesting stuff that

I've talked about in past videos. To be

clear about one thing, Dimensional did

not pay or otherwise incentivize me to

talk about their funds in this video. My

firm PWL Capital does use their Canadian

products and our clients portfolios. I

did a video a while ago explaining

Dimensional's history, which is closely

tied to the history of index funds, and

comparing their long-term performance to

comparable Vanguard index funds.