Russell 1000 Equal Weight Index

Capitalisation-weighted indexes remain the most popular form of index in use by financial practitioners because they are objective, practical and theoretically grounded. They are objective, in that prevailing market prices represent investors’ consensus view of the relative values of firms; they are practical, given that constituent weights in the index adjust as prices fluctuate; and they are grounded in two highly influential financial theories introduced in the 1950s and 1960s, the efficient market hypothesis (EMH) and the capital asset pricing model (CAPM).

In its strongest form, EMH states that securities are rationally priced by all investors, and that the price of a stock (and by inference, its market capitalization) reflects the issuing company’s true value. The CAPM introduces the concept of the market portfolio–all assets, weighted by their market value–and states that it has the highest level of expected return for its level of risk. In conjunction, these two theories imply that capitalization-weighted indexes are best suited both to measure the performance of active managers and to serve as the underlying performance target of index-tracking (passive) funds.

However, in the last two decades there has been rising interest in alternative index weighting methodologies using non-market cap weighting approaches. This implicitly recognizes some investors' belief that not all the tenets of the EMH and CAPM may be true.

Scepticism about markets’ efficiency may be a reaction to past periods of heavy concentration of capitalisation-weighted indexes in individual sectors and stocks. For example, the internet bubble of 1999-2000 was followed by a severe bear market. During this period, stocks from the technology sector gained particular prominence (see Figure 1). In its simplest form, equal weighting–an approach in which index constituents are given the same weight, rather than being determined by market values–is a way of addressing concerns about capitalisation-weighted indexes’ potential security concentration risks in its largest companies.

For example, an equal weight approach can be particularly useful in the large-cap size segment (the Russell 1000® Index), where a few companies, such as Apple and Exxon, may tend to dominate a capitalisation‑weighted index’s performance simply because of their size. While these outsized weights may benefit the index when large-cap stocks outperform, they can also hurt index performance when the reverse is true.

Equal weight indexes are the simplest type of alternatively-weighted indexes. By comparison with the standard index construction method of capitalisation weighting, in which constituents’ weights are determined by their respective market values, an equal weight index is indifferent to a stock's market value. Instead, constituent weights in an equal weight index are equalized at each rebalancing point. Additionally, equal weighting an index by sector then by constituent has historically produced excess returns.

In this paper we review some of the theory behind alternative weighting, highlight the recent increase in popularity of equal weighting and outline the innovative equal weighting methodology used for the Russell 1000® Equal Weight Index, in which both sector- and stock-specific risks are mitigated. We examine the resulting performance attributes of an equal weight index.