Improving our understanding of the equal weighted portfolio

Abstract

This thesis analyses the performance of the equal weighted portfolio using an approach from stochastic portfolio theory. This framework allows for the decomposition of the relative performance of the equal weighted portfolio into four main parts; the change in the concentration of the cap weighted portfolio, the excess return generated by a diversification benefit, the difference in dividend rates, and a term called the leakage effect. In general equal weighted portfolios do outperform their cap weighted portfolio counterparts, although with varying degrees across different countries. In South Africa, for example, high levels of leakage over the past ten years and increasing concentration have led to poor relative performance of the equal weighted portfolio. In other countries such as the United Kingdom and Japan, equal weighted portfolios have done very well, with high levels of diversification benefits and low levels of leakage. Two models are presented in an attempt to reduce the relative drawdowns of the equal weighted portfolio and to blend the two weights (equal and cap) in an optimal manner. These models appear to do well in markets where the equal weighted portfolio has poor performance and large relative drawdowns.