Last December we published an article discussing the relative performance of equal and cap-weighted benchmarks (Lost Decade for US Equity Markets? Hardly!), concluding that while the first decade of the millennium had been a “lost decade” for the cap-weighted benchmarks, the average stock produced positive absolute returns as well as positive returns after adjusting for inflation. As a quick review, the equally-weighted versions of S&P 500 and the Russell 1000 indexes consistently, and dramatically, outperformed their respective cap-weighted counterparts over the 10-years ending in 2009 (Chart 1). While the two benchmarks have similar capitalization ranges, the median market cap of the Russell 1000 is approximately half that of the S&P 500. This likely accounts for the larger differential between the equal and cap-weighted performance of the Russell benchmarks since the smaller end of the capitalization range significantly outperformed over the period in question.
The equally-weighted benchmarks outperformed their cap-weighted counterparts again in 2010 and have done so through the first five months of 2011. While the outperformance in 2010 was significant, it was far less dramatic than it had been in 2009 (Chart 2). This is not surprising. The rally from the bear market lows in 2009 was fueled by low-priced, low quality stocks, many of which had been priced for bankruptcy only to double, triple, or in a few cases, even quadruple from their lows. Having outperformed in nine of the last 11 calendar years and through the first five months of 2011, the average large cap stock, as measured by the equal-weighted benchmarks, has massively outperformed the cap-weighted indexes over the last 11+ years (Chart 3). Over the same time frame, CPI has averaged approximately 2.60%. As such, the average stock, as measured by the equally-weighted benchmarks, has produced positive real returns.
The point of this article is not to suggest that equity performance since the turn of the millennium has been strong. Simply put, it hasn’t been. True, the average stock has produced positive real returns, but so too have US Investment grade bonds and the risk-adjusted returns on bonds have been far superior. Nor is it our intention to suggest that equally-weighted benchmarks always outperform cap-weighted benchmarks. They don’t. The equal-weighted S&P 500 trailed the cap-weighted benchmark by 309bps annually from 1990 through 1999. Rather, our intention is to provide investors with prospective. While the last 11+ years have been challenging for domestic equities, it has not been the “lost decade” many would suggest. It would be more accurate to state that it has been a “lost decade” for the largest 100 companies by market capitalization and relatively weak decade for the rest of the US equity market. Cap-weighted benchmark performance often deviates significantly from the performance of the average stock and sometimes dramatically (Chart 4). As such, cap-weighted benchmarks may distort the underlying performance of the broader market, a factor we believe contributes to cycles of fear and greed among equity investors. Equally-weighted benchmarks simply provide a better proxy for the performance of the average stock within the market. Understanding the performance of the typical stock provides a better understanding of the underlying dynamics of the market, making equally-weighted benchmarks a useful tool.
Finally, this discussion brings us to a primary tenet of our investment management process: the implementation of our allocations (with the current exception of our commodity allocation) through active strategies. Passively owning a benchmark, be it equal or cap-weighted, results in the inherent acceptance of the risks associated with that benchmark. The main risks associated with an equity investment are the quality of a company’s business model, the competitive nature of the industry in which the company operates, and the price paid for the stock. These are active risks, i.e. they change over time, as do the risks associated with global asset classes. Both the absolute and relative risks associated with the government bonds of emerging and developed nations have changed radically in the last decade. At Blue Water Capital Management, we are first and foremost, risk managers. Abdicating our clients’ risk profile to global market allocations or benchmarks is anathema to our investment process. Therefore, we actively manage our allocations and utilize active managers with proven risk-management skills to manage each allocation. The history of the last decade has proven that passively allocating to cap-weighted benchmarks can be hazardous to one’s portfolio. Yet our decision to utilize active investment strategies is as much a function of risk management as it is a function of return enhancement. Sadly, this is an issue that is often lost in the active/passive debate, which tends to center largely around a discussion of absolute returns.