Portfolio Formation Strategies - The Equally - Weighted Portfolio
Equally-weighted-index

Definition of the equally weighted portfolio

This is a weighting algorithm that assigns the same weight (read importance) in each stock in an index fund or investment portfolio. As is therefore expected, the small companies in a given stock are assigned the same weight/ importance/ value as the largest companies within the same stock in an equal weight portfolio or fund.

As a result, it creates an even playing field. A perfect example is the Rydex S&P Equal Weight Exchange Traded Fund which gives the same exposure to small companies within S&P 500 as it does to large companies such as Exxon and General Electric among other corporate giants.

This weighting algorithm differs a great deal from the weighting algorithm most commonly used by portfolios and funds where stocks are weighted as per their market capitalizations. As a result, the equally weighted portfolio will have a higher stock turnover compared to a market-cap weighted index portfolio, hence will have a considerably higher trading cost.

Overview

In relation to general investment, equal weight basically refers to the practice of putting the same level of importance on each security that makes an investment portfolio or index fund. This approach allows you the investor to consider the stocks at your disposal without regard to the actual size of the company or a company’s market share. As such, the equally weighted portfolio does not rely on the market capitalization that is often the case with other weighting approaches.

Advantages of the equally weighted portfolio

  1. The index is much diversified with all stocks within the investment portfolio equally weighted

  2. Unlike market cap weighting portfolio, the index does not overpower/ overweight highly priced stocks and under-power/underweight lowly priced stocks. The pricing errors are normally random

  3. It is very easy to build a relatively tax efficient mutual fund and ETFs with the equally weighted portfolio

  4. This portfolio normally adds a 1-2% in the annual return over extended periods after expenses vs. market capitalization weighted indexes

Disadvantages of the equally weighted portfolio

  1. There is no difference made between the absolute or relative valuation of stocks within the investment universe

  2. It is hard to keep stocks within the index equally weighted because of the constant and unpredictable price fluctuations

  3. It is hard for this kind of index to manage significant amounts of money because of the need to invest the same amounts in both the smallest and largest stocks

The greatest benefit of the equally weighted portfolio is the fact that an investor is exposed to great and lucrative investment opportunities that may be underplayed when using other portfolio formation strategies. For instance, if the stocks of a given universe are evaluated on the basis of price, an investor is likely to get lucrative stocks to invest in, but can easily miss out on other lucrative deals by companies that are not within the same range when a price-weighted portfolio is used.

By the same token, by giving equal importance to all indices traded on the market, an investor is able to look past the big companies being traded in the marketplace. This means that an investor is in a better position to discover small yet lucrative entities for developing into potential investment opportunities for the future.

Important facts to keep in mind

With the equally weighted portfolio approach, one of the most critical things to remember is that the securities identified through this approach are likely to bear higher trading costs than those identified through other approaches. Generally, it is not unusual for securities funds that are evaluated using the equally weighted portfolio approach to have a higher turnover rate.

On condition that the stocks in question are promising some solid return in a predefined period of time, the slightly high costs of trading can easily be offset. As an investor, all you need to do is to hold onto your shares, and enjoy the upward swing as it lasts, then sell them just before the prices starts to level off.

On the flip side of the coin, though, as is with all other investment portfolio strategies, having an equal weight assigned to indices associated with a given portfolio is not a guaranteed way of earning a return.

You as the investor will still need to make wise and informed decisions on the future movement of your shares, the amount of return you can reasonably look forward to within a given trading time frame, and how that likely return will augur with the ultimate investment goals.

When you take these factors into serious consideration, and at the same time look at the risk or volatility associated with your selected investment portfolio, you can be able to increase the odds of making the trade worthwhile.

Conclusion

An equally weighted portfolio will weight each stock equally regardless of its economic size (earnings, sales, book value) or its market capitalization. Because of the daily movement of stock prices within the same index, the investment portfolio will need to be re-balanced constantly so as to keep the positions in each stock equal to the rest. 



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