The introduction of the S&P 500 Equal Weight Index (EWI) in January 2003 pioneered the subsequent development of non-capitalization weighted indices catering to investors who question market efficiency.

Equal weighting is factor indifferent. It randomizes factor mispricing and is thus an attractive option for proponents of the theory that the market is inefficient and at times misprices factors.

The Equal Weight Index has different properties from the S&P 500, including a lower concentration of individual stocks and slower-changing sector exposures.

The S&P 500 EWI has outperformed the S&P 500 since its inception. The level of outperformance has varied considerably under different market conditions.

The outperformance of the two indices is a result of the differing weighting and rebalancing processes. In terms of risk factor exposures, a complex and dynamic combination of size and style risk factors have contributed to the difference in returns. It may be difficult to replicate S&P 500 EWI return outcomes through a simplistic combination of style and sector indices.

Equal weighting also demonstrates long-term outperformance internationally.

Criticism of equal weighted indices has centered on additional turnover and increased capacity constraints relative to a market capitalization weighted index. While true in abstract theory, neither is a serious hurdle in practice.

THE S&P 500 EQUAL WEIGHT INDEX AND ALTERNATIVE WEIGHTED INDICES

Since the introduction of the S&P 500 in 1957, most indices have been weighted by market capitalization. The theoretical underpinnings for market capitalization weighted indices as a basis for investment lie in the Capital Asset Pricing Model (CAPM) and the Efficient Market Hypothesis. According to the CAPM model, the expected return implicit in the price of a stock should be commensurate with the risk of that stock. However, stocks are subject to two types of risk - systematic risk, resulting from potential movements in market factors, and unsystematic risk, resulting from factors associated with individual assets. Since unsystematic risk can be diversified away stocks should be priced solely based on systematic risk. This also implies that it is optimal to hold a well diversified portfolio in order to minimize unsystematic risk for a given level of expected return. According to the efficient market hypothesis it is impossible to beat the market because prices already incorporate all relevant information. Based on this the most efficient portfolio would be the entire market, and a broad market capitalization index would represent the optimal investment. However, there is much debate as to how efficient the market is in practice. Thus there are countless different strategies being used in an attempt to beat the market. This has led to indices being created based on alternative factors which measure different strategies.

From a methodological standpoint, all equity indices can be thought of as being weighted by a certain factor raised to a power, as shown below:

The factor used can be one of any number of attributes, including market capitalization. If it is desired to amplify the influence of the factor, an exponent can be applied. For instance, to achieve a portfolio with as high a dividend yield as possible, the index could be weighted based on dividend yield squared. In general, however, most indices do not use an exponent and are therefore weighted by a factor or a score derived from several factors. The S&P 500 Equal Weight Index is unique in that its methodology is defined not by the factor used but by the exponent. In an equal weighted index the exponent used is zero. Therefore, regardless of what factor is used the overall score for each component stocks is always one and the weight of each stock in the index is always one divided by the total number of components in the index. Since the index is factor indifferent, it randomizes factor mispricing and is thus an attractive option for proponents of the theory that the market is inefficient and at times overweight or underweight certain factors.

At the time of its release on January 8, 2003 the S&P 500 Equal Weight Index (EWI) represented the first major equity index to use an "alternative" weighting methodology. Since the introduction of the S&P 500 Equal Weight Index, several indices and index families using alternative weighting schemes have been developed, examples of which are shown in Exhibit 1. (It was certainly not the first non-market capitalization weighted index - MSCI GDP weighted indices and GRA wealth weighted indices were published in the 1990's - but it was the first such index to be widely used for index products.)

There has also been strong interest in the S&P 500 EWI itself since the introduction of the index. Assets linked to the index have increased rapidly since the launch of the index, as illustrated in Exhibit 2.

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