Relative Performance: Equal or Market Capitalization Weighted Index?

Using SCHA and SCHX as proxies for Small and Large cap equity markets, I attempt to measure cumulative relative performance over one (1), two (2), and three (3) year time periods.

The S&P 500 is a market capitalization weighted index, meaning the biggest companies have the biggest weights in the index. The Dow Jones Industrial Average (DJIA) is a price weighted index. So companies with large stock prices are weighted heavier. (Example: Goldman Sachs at $230 has much more weight than Intel at $34). There are also equal weight indexes (Ticker: RSP). These weight each stock in the index equally, regardless of price or market cap. (Ex: 60 stocks, each gets 1/60th weighting.)

Investing your money in a market cap weighted index leaves you relatively more exposed to larger companies, where equally weighted indexes leave you more exposed to smaller caps. Price weighted indexes have very little mathematical basis, other than they’re easy to understand. Price weighted indexes are not good representation of changes in value of the stock market, thus we ignore them in this exercise.

Small cap stocks tend to exhibit more price movement, i.e. more volatility. More risk, more reward. On average, small caps will outperform in a bull market, but under-perform in a bear market. The strategy goes, overweight small caps when times are good, overweight large cap value (Walmart, Walgreens) when times go sour.

Here’s the relative cumulative performance of Small/Large Cap equities. A number above one (1) means small cap is outperforming, while a number less than one (1) means Large Caps are outperforming.

rp_largesmall

 

The above graph shows relative cumulative performance starting in March of each year. Example, blue line shows 36 month relative cumulative returns, while the green line shows the 12 month relative cumulative returns.

Since Trump took office in November of last year, we’ve seen a bump in small caps, then a subsequent sell off, relative to large caps. Small caps popped first, then large caps followed. However, small caps have outperformed relatively since last year, while large caps have performed better since three (3) years ago.

We need to compare this to an average ratio for each time period (far right column). Note: these are weekly returns (March thru March).

smalllargetable

Large Cap have outperformed Small Cap over the last three years, pretty significantly, and under-performed over the last twelve (12) months.Thus, equal weight has outperformed over the past year as we see below. However, Large caps have made a *Huge* rally relative to small caps since February. Here we used RSP and SPY as proxies for equal and market weighted indexes.

rp_eq_mkt

Strategy: Large Caps were over valued last March, but Small cap valuations are catching back up. Buy equal weight for the 6-9 month time period, then re-evaluate relative performance. Note: Tax reform will help Small cap over Large cap, so watch for tax reform in late summer,early fall (LINK, Fortune).

Disclaimer: this article is designed to help you choose between Equal or Market cap weighted indexes; I’m not advocating specific securities. This is only one measure of relative valuation, do more research on your own before purchasing securities. I do own SCHA.

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