We have gotten a number of great questions from folks trying to understand the apparent outperformance of the Equal Weight All-Sector rebalance algorithm we have shared as sample Quantopian live trading algorithm. The answer seemed lengthy enough to warrant a new post on the topic.
This algorithm is designed to maintain a constant equal-weighted exposure across all equity market sectors using a basket of sector ETF products rebalanced monthly. To understand how and why there are differences in returns to an equal-weight all sector strategy, as compared with simply buying and holding an S&P 500 Index ETF (like SPY) we need to compare the relative sector exposures of each strategy. The SPY seeks to track the performance of the S&P 500 Index, which is a "market cap weighted" index – meaning that each stock is held according to their current size. A snapshot taken as of market close on April 14th reveals that the equal-weighted strategy currently holds a portfolio that is overweight utilities, materials and consumer staples sectors, and underweight health care, financials and technology versus the all market S&P500.
During times of high cross-sector correlation in the markets, this over/underweight exposure will be relatively insignificant and the equal-weighted strategy will tightly track the overall market. However, during times of variable cross-sector performance, for example the recent steep tech sell-off, the equal-weighted strategy returns can deviate significantly from the overall market.
In general you can think of a market-cap weighted strategy as being a momentum strategy in that stocks with recent outperformance and hence growth are rewarded with a larger weight in the portfolio (e.g. the current overweight positions in HC, Financials and Tech in the SP500). Conversely, an equal-weighted strategy is by nature a mean reversion strategy, in that with each rebalance back to equal-weight you will actually be trimming recent ‘winners’ and buying recent ‘losers’ to maintain a constant exposure.
While neither strategy is guaranteed to win in the future, this backtest shows that over the last 12 years or so (from January 2002 through today) an equal-weighted strategy would have beaten out the market-cap weighted SPY.