Equal-Weighting S&P 500
July 12, 2015
Inflation- and Dividend-Adjusted Market Peaks
The popular market-proxy S&P 500® index is market-cap weighted. This is one of the factors that helps reduce the turnover of ETFs tracking this index. For example, the iShares Core S&P 500 ETF (IVV) has a turnover rate of only 4%. The following chart, produced by the Alpholio™ App for Android, shows the characteristics of a portfolio composed solely of this ETF:
(Note that Alpholio™ uses a broader ETF as a representation of “the market”; hence, the beta of IVV is different from the conventional one and alpha from zero.)
However, market-cap weighting implies that the largest companies’ stocks have the highest impact on the index. While returns of mega-caps in the index tend to be less volatile, they are usually lower than those of their smaller-cap peers. To overcome this limitation, other ETFs weight equities in the index differently. For example, the Guggenheim S&P 500™ Equal Weight ETF (RSP) assigns each of the 500 stocks a 0.2% weight. This tilts RSP toward smaller-cap equities in the index and results in a 18% turnover. Over the same analysis period, RSP produced markedly higher returns than IVV but at the expense of an elevated volatility and a slightly lower Sharpe ratio:
In addition to overweighting of mega-caps, some economic sectors in the index dominate others, as shown in the latest edition of S&P Capital IQ The Outlook:
To counteract this, the ALPS Equal Sector Weight ETF (EQL) applies the same weight to nine sectors (with telecommunication services considered part of information technology). Here are the characteristics of a portfolio consisting solely of this ETF over the identical analysis period:
While the annualized return of EQL was lower than than of IVV or RSP, it was more than adequately offset by a decrease in volatility, which resulted in an improved Sharpe ratio and maximum drawdown.
What if the investor wanted to equal-weight all ten sectors instead of just nine, i.e. keep telecoms separate from IT? To do so, the investor could construct a portfolio of Vanguard sector ETFs, excluding the Vanguard REIT ETF (VNQ). That is because real estate stocks are currently part of the financials sector and not expected to become a separate asset class until mid-2016. Here is how such a portfolio, rebalanced quarterly (just like EQL), performed over the same analysis period:
The Vanguard sector portfolio had the second highest alpha and Sharpe ratio as well as the second lowest standard deviation (a measure of volatility of returns).
The above analysis period was dictated by the inception date of the EQL, the youngest of all the ETFs used. Arguably, this approximately six-year period may be considered too short and not representative of performance over a full economic cycle. However, it was interesting to see that while equal-weighting the index on a security level produced highest absolute returns, equal-weighting on a sector-level delivered the highest risk-adjusted returns.
To conduct your own analyses of various ETF portfolios, download the Alpholio™ app from
December 26, 2013
Turn-of-the-Year Market Trends
With a strong performance of equities in 2013, major market indices have reached peak levels. In an attempt at accuracy, many articles in the financial media adjust index values for inflation. The conclusion is that the market, as measured by the Dow Jones Industrial Average (DJIA), has surpassed record levels from early 2000 only very recently on an inflation-adjusted basis. On the other hand, a broader market benchmark, the S&P 500® index, is still about 15% below its inflation-adjusted 2000 peak. Having suffered significant downturns in both 2000 and 2008, the NASDAQ-100 index is significantly below both its nominal and inflation-adjusted historical highs.
The problem is that in all of these assessments, a price level of each index is used. Would the findings be different if indices were also adjusted for reinvested dividends to account for total returns? To determine that, Alpholio™ compiled inflation- and dividend-adjusted prices of two representative exchange-traded funds: the SPDR® Dow Jones® Industrial Average ETF (DIA) and SPDR® S&P 500® ETF (SPY). These ETFs are long-lasting and popular implementations of their respective indices. To adjust for inflation, the Consumer Price Index – All Urban Consumers (CPI-U) was used.
A conventional price chart shows that DIA has indeed just matched an inflation-adjusted record high from January 2000:
However, a chart for DIA with reinvested dividends indicates that the previous inflation-adjusted peak from October 2007 was already surpassed in mid-January 2013:
Similarly, a price-only chart illustrates that SPY is still about 13% below its inflation-adjusted top from March 2000:
On the other hand, the chart with dividends factored in demonstrates that SPY already exceeded the previous inflation-adjusted maximum level in May 2013:
According to S&P Capital IQ, since the late 1920s dividends constituted about 45% of the total return of the stock market. Therefore, any assessment of the current market level has to adjust not only for inflation but also for reinvested dividends. From that standpoint, historical market peaks were quietly surpassed much earlier this year. Time and again, media focus is on generating simplified headlines rather than noting true events.
December 17, 2013
Year-End Market Predictions
‘Tis the season for the usual pondering of the turn-of-the-year market trends. A report from the Merrill Lynch Equity and Quantitative Strategy team shows that January has statistically delivered the highest monthly returns and second-highest (after December) frequency of positive returns in all months:
In contrast, a blog post in The Wall Street Journal demonstrates that the December rally is more pronounced and consistent across observation timeframes than the January one, which vanished in the last 20 years:
However, from a monthly peak-close perspective, December is unremarkable, as an article in The Wall Street Journal illustrates:
This finding is less meaningful because it only determines the magnitude of monthly oscillation, rather than a complete return in each month.
According to the post, an interesting return pattern emerges in the last and first month of the year:
A pullback in the middle of December is caused by tax-loss selling by traders, window dressing by fund managers, and portfolio realigning by investors. Once this is over, a rally ensues. However, according to the article, it is statistically significant only in a short period at the turn of the year:
There is one version of the Santa Claus rally that enjoys strong historical support: the last five trading sessions of December and first two of January… Since the Dow was created in 1896, it has gained an average of 1.7% during this seven-trading session period, rising 77% of the time. That is far better than the 0.2% average gain of all other seven-trading-session periods of the calendar.
Here is how the S&P 500® returns look so far this December, as compiled by Alpholio™:
Despite a pullback early in the month, there is some similarity to the above long-term average return pattern. Of course, only time will tell if the rest of the pattern is followed.
The seasonal effects are mostly pronounced in small-cap stocks. In addition, the report claims that lower-quality stocks strongly outperform in January:
Loading up on “junk” equities for the sake of a superior one-month return is probably not advisable. If anything, this might be an opportune time to tilt the portfolio towards high-quality, cash-rich companies, which Merrill Lynch itself recommends in its 2014 outlook. Seasonal market trends, such as the Santa Claus rally or January effect, no matter how likely, should not cloud a long-term investment perspective.
December 12, 2013
At year’s end, many analysts make market predictions for the next twelve months. The S&P 500® index is a popular target for such forecasts since it is commonly used as a market proxy and its constituent stocks are widely followed. Hence the bottom-up analysis — a sum of estimates for all individual equities makes an index forecast.
Who better to predict the S&P 500® index level than the S&P itself? Let’s take a closer look at their forecast accuracy. The following chart compares the predicted to actual values of the index, which Alpholio™ compiled from historical editions of S&P Capital IQ’s The Outlook:
To be exact, these 12-month targets were typically set in early to mid December of the preceding year, while the actual index values were recorded on the last trading day of the predicted year. Also, dividends were not taken into account in this price index.
The immediate takeaway from this chart is that the forecast for 2008 vastly overestimated the actual price: 1,650 vs. 903, or by about 83%! The financial crisis and its magnitude caught everyone, including members of the S&P Capital IQ’s Investment Policy Committee, by surprise. Excluding that outlier year, here are the index prediction and annual return statistics:
||Prediction vs. Actual
||Actual Index Return
The sample is admittedly small, under ten data points. But a trend is emerging — on average, S&P predictions underestimated the actual index. This tendency is further illustrated by the following chart from FactSet’s Targets & Ratings report:
The chart shows how a bottom-up target price (dashed line) moved almost in parallel with the actual index (solid line) in the 12 months through October. In other words, predictions were adjusted upwards with a lag as it became evident that original estimates were likely going to be soon surpassed. (As a side observation, almost half the stocks in the S&P 500® were rated a Buy, slightly less than half a Hold, and only about 5% a Sell. Even a booming market, a less optimistic distribution would be intuitively expected.)
S&P offers another interesting prediction for the next year:
We also believe 2014 could be one of those years in which the S&P 500 is up for the entire year but suffers through a pullback of 5%-10% (and more likely a correction of 10%-20%) before ending the year higher than where it started. One reason is that 26 months have elapsed without the S&P 500 slipping into a correction, versus the average of 18 months (and median of 12 months) between declines of 10% or more since 1945.
If statistically the market is overdue for a correction, let’s also hope that by the same token S&P underestimated the 500® index’s value in 12 months from now. In that case, we should be expecting a price of about 1930 instead of the current target of 1895, while keeping in mind that perfect market predictions are virtually impossible.