Equal weighting and fundamental weighting are both smart beta investment strategies that sever the link between price and portfolio weight and are known to earn long-term excess returns over capitalization-weighted indices. Equally weighted and fundamentally weighted strategies are not, however, equivalent in their performance or their cost structure. The gross performance of equally weighted strategies generally falls behind that of fundamentally weighted strategies largely because of selection bias. Additionally, net performance is affected by transaction costs that grow much faster with the size of assets in equally weighted strategies.
Much of the outperformance of the fundamentally weighted versus equally weighted strategy is due to the selection effect. Using market capitalization as a criterion to select stocks for the equally weighted strategy favors high priced, potentially overpriced, stocks. Conversely, a fundamentally weighted index will typically include companies with large fundamental weights, but with low market capitalization, which may be potentially underpriced. In addition, equally weighted strategies suffer from higher implementation costs than a fundamentally weighted strategy. Equally weighted indices have a much larger exposure to small-cap stocks that have higher bid–ask spreads and are less liquid. The RAFI Fundamental Index may lag equally weighted and/or market-capitalization-weighted indices in a momentum-driven market or markets driven by a small number of mega-cap stocks.
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