The Great Weight Debate: Alternative Weighting Strategies Revisited

Michael Johnston, ModeratorCo‐Founder & Managing DirectorETF Database

Anthony Davidow, PanelistManaging Director, Portfolio Strategist Guggenheim Investments

Joel Dickson, PanelistPrincipal, Investment Strategy GroupVanguard

Rick Ferri, PanelistFounder, Investment Committee of Portfolio Solutions

Weighting Methodologies 101Index Construction• Security Selection (Who Gets In)• Security Weighting (Where They Sit)

Alternative Weighting Strategies In ETFs:• Market Capitalization• Price• Equal• Equal Sector• Dividends• Dividend Yield• Earnings• Revenue• Multi‐Factor Fundamental (e.g., RAFI)

Impact Of Weight DecisionsSimilar Stocks  Different Results

• Large Cap U.S. Stocks In 2011: 

ETF Methodology 2011 Return

SPY Market Cap. 1.18%

RSP Equal ‐0.68%

EQL Equal Sector 2.58%

RWL Revenue ‐0.27%

EPS Earnings 3.64%

DLN Dividend 9.44%

The Great Weight DebateThe BIG Questions

• Is Cap Weighting Flawed?

• Understanding Risks / Biases

• What Does The Data Say?

• Alternative Weighting = Opportunity For Client Portfolios ??

A Tale of Two Index Types

Benchmark Indexes (1923)Broad selection – cap weighing

• Market valuation• Defines Beta (mkt. risk)• Economic indicator• Asset allocation modeling• Performance measure• Index funds in 1975

Strategy Indexes (2003)Alternative selection/weighing

• Intelligent indexing• Active indexing• Indexing 2.0• Smart indexing• Alternative Beta• 100% product driven

Index Strategy Map

Quantitative

Screened

Passive

Cap

italiz

atio

n

Fixe

d W

eigh

t

Fund

amen

tal

Secu

rity

Sele

ctio

n

Security Weighting

The Case For Equal Weight ETFs

Performance1

An alternative to traditional cap-weight index and actively managed core portfolios, equal weighting presents the opportunity for more consistent risk-adjusted performance results.

Disciplined RebalanceSystematic reallocation from outperforming to under performing stocks and market segments may provide enhanced risk control and the opportunity to capture long-term equity market performance.

Diversification2

Broad diversification across market segments may help reduce concentration risk and result in more balanced exposure across market capitalization, sectors, and other broad risk factors.

1EW ETFs may under-perform the market when certain market caps are in favor. 2Diversification neither assures a profit nor eliminates the risk of experiencing investment losses.

Diversification = Reduction of Concentration Risk  

•The S&P 500 Cap Weight Index is a concentrated bet on Mega-Cap Stocks

8

S&P 500 3 Year Average Top 10 Holdings (as of 12-31-2011)

% of index portfolio S&P 500 Cap-Weight

S&P 500EW Weight

Exxon Mobil Corp. 3.6 0.2Apple Inc. 2.2 0.2Microsoft Corp. 1.9 0.2Procter & Gamble Co. 1.7 0.2General Electric Co. 1.7 0.2Johnson & Johnson 1.7 0.2International Business Machines Corp. 1.7 0.2Chevron Corp. 1.7 0.2AT&T Inc. 1.6 0.2JPMorgan Chase & Co. 1.5 0.2Top 10 Names 19.4 2.0

Next 40 Names 30.8 8.6Top 50 Names 50.1 10.6

Source: FactSetThis page compares the capitalization ranges of the securities within S&P 500 Index against RSPS&P EWI. Decile 1 includes the top ten % largest securities and Decile 10 includes the bottom 10% smallest securities, based on the S&P 500 Index weightings. Each Decile % has been rounded to the nearest whole percent. S&P EWI rebalances on a quarterly basis to equal weight each constituent. Weightings are subject to change.

As of 12.31.2011% of index of portfolio

Larget Decile Smallest Decile

Market Cap Decile Analysis

0

10

20

30

40

50

60

MC Decile 1 MC Decile 2 MC Decile 3 MC Decile 4 MC Decile 5 MC Decile 6 MC Decile 7 MC Decile 8 MC Decile 9 MC Decile 10

S&P 500 EW TR S&P 500 TR

EW strategies receive a larger contribution of return from smaller constituents in the

portfolio

SP 500 Top 50 Names are > 50% of the Index; the remaining 450 names are < 50%

Demonstrating S&P 500 EW Reduction of Concentration Risk

Upside DownsideAnlzd Return Anlzd StdDev Capture % Capture % Anlzd Alpha Sharpe Ratio Info Ratio Sortino Ratio

Statistic Statistic Statistic Statistic Statistic Statistic Statistic Statistic

Upside DownsideAs of 12.31.11 Anlzd Return Anlzd StdDev Capture % Capture % Anlzd Alpha Sharpe Ratio Info Ratio Sortino Ratio

Statistic Statistic Statistic Statistic Statistic Statistic Statistic StatisticS&P 500 Equal Weight Index 9.43 18.52 173.43 105.58 2.27 0.41 0.64 0.61S&P 500 Index 6.16 15.12 100.00 100.00 0.00 0.28 0.40

Peer Group 5th Percentile Return 7.89 18.46 132.21 106.73 1.80 0.38 0.42 0.56Peer Group 25th Percentile Return 6.31 16.20 107.33 102.78 0.43 0.30 0.04 0.43Peer Group Median Return 5.52 15.38 96.51 100.61 -0.46 0.24 -0.18 0.34Peer Group 75th Percentile Return 4.71 14.65 83.82 97.75 -1.26 0.18 -0.45 0.26Peer Group 95th Percentile Return 3.29 12.97 67.26 90.18 -2.61 0.10 -0.97 0.13

Peer Group = Lipper Large Cap Core Funds: 584 funds in the Universe

0

1

2

3

4

5

6

7

8

9

10S&P 500 Equal WeightIndex

S&P 500 Index

Peer Group 5th PercentileReturn

Peer Group Median Return

Peer Group 95th PercentileReturn

12

14

16

18

20

22

24

20

60

100

140

180

220

260

300

85

87

89

91

93

95

97

99

101

103

105

107

109

-3

-2

-1

0

1

2

3

0.0

0.1

0.2

0.3

0.4

0.5

-1.2

-0.8

-0.4

0.0

0.4

0.8

0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

S&P 500 EWI vs. S&P 500 and Large‐Cap Universe (January 8, 2003* – December 31, 2011)

Source: Factset; Lipper data. * Inception of S&P 500 EWIPerformance displayed is past performance, which is no guarantee of future results. Index performance is not meant to represent performance of any fund. The referenced indices are unmanaged and not available for direct investment. Index returns do not reflect any management fees, transaction costs or expenses.

Market capitalization represents not just one risk factor but all risk factors• Market capitalization captures all potential factors that all investors collectively use 

to determine a stock’s price

Or do other factors matter as well?

Accounting irregularitiesBusiness modelCompetitive landscapeCorporate governance controlsCounterparty exposureExpected growthForward-looking expectationsHedging activityIndustry outlookInput pricesInternational operations

LeverageLiquidityManagement effectivenessMarket shareNatural disastersNew products/lines/businessOff-balance sheet itemsProfits Regulatory environmentShare repurchasesSupply chains

Should an investor focus only on some factors?

AssetsBook valueCash-flow

DividendsSalesVolatility

Any other factor used by market participants

Dissecting the pitch: Alternative indexes form a better portfolio core

The architects of alternative strategies believe their chosen factors/parameters will lead to outperformance

• Most alternative weighting schemes are based on a clearly defined set of rules

• These metrics are based on freely available public information

• Is “outperformance” that easy?– Investors should not assume that a firm’s size represents a “free 

lunch” to be exploited by simply reallocating equity weights

Security and sector bets lead to a systematic tilt toward value and smaller stocks

Performance has been driven by size and style biases

Notes: The 3-factor Fama French model is as described in Fama and French (1993) and Carhart(1997); we display the risk factor exposure of the alternative index relative to its cap-weighted counterpart index (i.e.- the difference in the regression coefficients). We used the following comparisons beginning in 1986 due to the availability of the Russell size and style benchmark returns, with the actual date range depending on the availability of returns data for each alternatively-weighted index: S&P 500 equal weighted vs. S&P500 (1990-2011); Dow Jones US Select Dividend index vs. DJ Total Stock Market (1992-2011); FTSE RAFI 1000 vs. Russell 1000 (1986-2011); and, FTSE All-World RAFI 3000 vs. FTSE All-World (1999 – 2011). Sources: Vanguard, based on returns data from Morningstar, Russell, S&P, Dow Jones, FTSE, and Ken French’s Website.

-0.2

-0.1

0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

Market - Rf(Broad Market Risk Factor)

SMB(Small Cap Risk Factor)

HML(Value Risk Factor)

Alte

rnat

ive

inde

x re

gres

sion

coe

ffic

ient

Min

us C

ap-w

eigh

ted

regr

essi

on c

oeff

icie

nt

Alternative index risk-factor exposure relative to cap-weighted counterpart index

Equal Weighted Dividend Weighted RAFI US RAFI Global

Small‐cap and value performance is time‐period‐dependent

Source: Russell and Vanguard Investment Strategy Group. Rolling cumulative return differentials, as of December 31, 2010.

Identifying true mispricings ex ante is extremely difficult

After accounting for size and value tilts, “alpha” may disappear

Notes: Chart displays the t-statistics for the constants (style-adjusted alphas) from a 36-month rolling regression of the returns of each alternative index on the three Fama-French risk factors, as discussed in Fama and French (1993) and Carhart (1997). A value outside of the significance bands would indicate a regression constant (alpha) that is statistically different from 0 at that given significance level. Data as of May 31, 2011.Sources: Morningstar, Inc., and website of Kenneth R. French: http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html

-5

-4

-3

-2

-1

0

1

2

3

4

5

1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

t-sta

tistic

for r

egre

ssio

n co

nsta

nt

Alpha t-statistics from 36-month rolling three-factor model

S&P 500 Equal Weighted Index Dow Jones U.S. Select Dividend IndexFTSE RAFI All-World 1000 Index FTSE RAFI All-World 3000 Index~ 0.05 Signif icance ~ 0.01 Signif icance

Important informationMutual funds and all investments are subject to risk. Mid‐ and small‐capitalization stocks historically have been more volatile than large‐cap stocks. For U.S. investors, foreign markets present additional risks, including currency fluctuations and unfavorable developments in a particular country or region. Stocks of companies in emerging markets are generally more risky than stocks of companies in developed countries. Funds that concentrate on a relatively narrow sector face the risk of higher share‐price volatility. It is possible that tax‐managed funds will not meet  their objective of being tax‐efficient. Because it concentrates on a single stock, a company stock fund is considered riskier than a stock mutual fund, which is diversified. 

“FTSE®” and “FTSE4Good™” are trademarks jointly owned by the London Stock Exchange plc and The Financial Times Limited and are used by FTSE International Limited under license. The FTSE4Good US Select Index is calculated by FTSE International Limited. FTSE International Limited does not sponsor, endorse, or promote the fund; is not in any way connected to it; and does not accept any liability in relation to its issue, operation, and trading. 

Standard & Poor’s®, S&P®, S&P 500®, Standard & Poor’s 500, 500®, S&P MidCap 400®, and S&P SmallCap 600® are registered trademarks of Standard & Poor’s Financial Services LLC (“S&P”) and have been licensed for use by The Vanguard Group, Inc.  The Vanguard mutual funds are not sponsored, endorsed, sold or promoted by S&P or its Affiliates, and S&P and its Affiliates make no representation, warranty, or condition regarding the advisability of buying, selling, or holding units/shares in the funds. 

The Russell Indexes and Russell® are registered trademarks of Russell Investments and have been licensed for use by The Vanguard Group. The products are not sponsored, endorsed, sold or promoted by Russell Investments and Russell Investments makes no representation regarding the advisability of investing in the products.The funds or securities referred to herein are not sponsored, endorsed, or promoted by MSCI, and MSCI bears no liability with respect to any such funds or securities. For any such funds or securities, the prospectus or the Statement of Additional Information contains a more detailed description of the limited relationship MSCI has with The Vanguard Group and any related funds.

Vanguard Marketing Corporation, Distributor of the Vanguard Funds. U.S. Pat. No. 6,879,964 B2; 7,337,138; 7,720,749; 7,925,573.

The Great Weight Debate: Alternative Weighting Strategies Revisited

Michael Johnston, ModeratorCo‐Founder & Managing DirectorETF Database

Anthony Davidow, PanelistManaging Director, Portfolio Strategist Guggenheim Investments

Joel Dickson, PanelistPrincipal, Investment Strategy GroupVanguard

Rick Ferri, PanelistFounder, Investment Committee of Portfolio Solutions