An equal weighted bonds basket

Among the “new indexing strategies” that have entered the Australian marketplace recently is equal weighting.  This type of indexing gives the same weight to each security in the index fund or exchange-traded fund (ETF). 

The traditional weighting scheme used for more than 40 years by index funds and benchmarks is market capitalisation (market cap) weighting.  Market cap is the total value of the issued shares of a listed company, and equals the share price times the number of shares.  The composition of indexes or benchmarks using market cap weighting is based on the premise that all the information about a company is already priced into the market.  It also assumes those markets and participants are efficient, supporting the assertion that the market cap represents the true value of a company.

Regardless of the long history of market cap indexes, there has been increasing interest in equal weighting.  This may be due to investment managers seeking alternative indexed products to market to their clients, which push the boundaries of traditional indexing (and may earn the managers higher fees than traditional indexing).  Despite the association by name, other forms of indexing such as equal weighted indexing are not guaranteed to provide the same risk and return outcomes as market cap weighting,

In the US there have been some strong outperforming equal weighted ETFs – especially in the equity space, with the reason for the outperformance predominantly due to a size bias.  In particular, this has been supported by US small caps outperforming the broad market over the last 10 years. Equal weighting increased the holdings in small cap companies relative to the average market cap for the market cap weighted index.  Backfilling the history of the equal weighted ETF to the 1990s would change the outcome, with equal weighting underperforming a market cap weighted index due to small caps not doing as well (see Figure 1, which shows the US Small Cap index versus the S&P 500 index).

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Investors may be interested by these alternative types of indexed products in Australia, following their relative success in the US.  The number of bond ETFs listed on the ASX that use equal weighting is limited to three products provided by Russell.

The equal weighted share products available for investment are discussed by Tony Rumble in Equal weighting: an alternative indexing strategy in this edition of the Eureka Report.

The three bond ETFs that use equal weighting are: Russell Government Bond ETF, Russell Semi-Government Bond ETF, and Russell Select Corporate Bond ETF. 

The Russell products also use benchmarks that are equal weighted, so the performances of the ETFs are close to these benchmarks.

As you can see below in Figure 2, the Russell ETFs (as shown by the blue columns) have performed differently compared to the market cap weighted indexes (red columns).  It is important to the note that the period of performance is two years.  This is a short period of time to analyse performance, but it does show that equal weighting and market cap indexes can have quite different outcomes.

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Note:  The past performance of the Russell ETFs is not indicative of future performance.  The market cap weighted benchmarks used for comparison are the Bloomberg Australia Sovereign Index and Bloomberg Australia Investment Grade Corporate Bond Index.  Due to the lack of data for the semi-government sector, the Bloomberg Australia Sovereign Index has been used for comparison, although it is not truly representative as it is only exposed to government bonds.  A semi-government index’s performance would probably fall between the Sovereign and Corporate index.

For the bond market over this time period the equal weighted indexes have generally underperformed market cap indexes.  Due to the cyclical nature of markets and economies, different assets will perform differently at various stages of the cycle.

The Russell ETFs are very focused in their exposure to a particular segment of the bond market.  Each ETF holds less than six securities, which are held in almost equal weights, and the ETFs fully replicate their underlying benchmarks. 

The advantages to investors are that the Russell ETFs allow investment into a particular sector of the bond market.  The Russell ETFs provide exposure to unlisted bonds, which generally are not accessible to small investors due to the large minimum investment required.

In comparison, a market cap weighted ETF may be more diversified, holding sometimes over 100 securities depending on the benchmark used.  So the largest position will be based on the largest market cap weight, and vice versa for the smallest position.  Arguments used against market cap weightings is that it results in buying high and selling low – so bonds that have performed will continue to be bought while underperformers are sold. 

A disadvantage of equal weighting it that it may require more rebalancing, by selling the outperformers and buying the underperformers on a regular basis.  The result can be a tilt towards the underperforming bonds, which have been assumed to be undervalued.  This may be fine during strong markets, but during downturns the performance may suffer compared to traditional indexes. 

Equal weighting also may tilt a bond portfolio towards bonds with higher expected returns – not such a bad outcome, but it could mean that the bonds have a higher default risk.  The higher expected return compensates for the higher risk.

Both methods of weighting securities have their positives and negatives, but due to the short history available for equal weighted bond ETFs it is difficult to ignore a model of valuing securities that has a proven long history.  Only time will tell.