It’s a year old, but it’s still sweet. A chart from Tom Brakke’s Research Puzzle pix comparing the performance of the S&P500 and its equal weight counterpart from 2000 to March 2011:
Tom thinks the phenomenon might reverse:
At some point, however, this trade will flip back in a major way and the market-weighted indexes will be formidable competitors. Will it only be when the market corrects? We know from the 1990s that that doesn’t have to be the case — the biggest stocks can lead in an up market. But whatever the cause of the change, should the behemoths that have been lagging get traction, it will cause significant disruption in a pattern that has gotten pretty comfortable.
For the reasons I’ve set out this week, I think that market cap-weighted indices suffer from the systematic flaw that they buy more of a particular stock as its market capitalization increases. A market capitalization-weight index will systematically invest too much in stocks when they are overpriced and too little in stocks when they are priced at bargain levels. An equally-weighted index will own more of bargain stocks and less of overpriced stocks. Since stocks in the index aren’t affected by price, errors will be random and average out over time.