The Russell 1000 Equal Weight Sector Indexes: A simple and effective smart beta approach

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1 INDEX INSIGHTS The Russell 1 Equal Weight Sector Indexes: A simple and effective smart beta approach By: David A. Koenig, CFA, FRM, Investment Strategist FEBRUARY 215 Key points: Equal-weight indexes were the earliest and simplest index-based strategies to break the link between a stock s price and its weight in an index, avoiding having a few large companies dominate index performance simply because of their size. By spreading positions evenly across constituents and systematically rebalancing back to target weights, equal-weight indexes have historically benefited from this diversification and from reallocating constituent exposures contrary to market movements which can at times push stock prices meaningfully above or below intrinsic value. An equal-weight sector index can provide a guide for investors to allocate their portfolio exposures more evenly across all constituents in the sector. Such diversification has historically had a meaningful effect on performance, particularly in some of the more dynamic sectors, such as Technology, Health Care, 1 Producer Durables and Consumer Discretionary. The introduction of non-market-cap-weighted indexes and the growth of smart beta indexes mark some of the index industry s most significant innovations of recent years. Among such indexes, equal-weight indexes have the least complex methodology and were the first to break the link between a stock s price and its weight in the index. A key characteristic of equal-weight indexes is that they are agnostic to factor exposures, offering the potential for market participants to benefit from market inefficiencies without requiring them to take a view on which factors are driving returns at any given time. By spreading exposures evenly across the opportunity set, equal-weight indexes avoid the concentration that can occur in market-cap-weighted indexes, where a few large companies can dominate index performance simply because of their size. Equal-weight indexes also benefit from systematic quarterly rebalancing back to targeted weightings, often in opposition to market sentiment which can push stock prices above or below intrinsic value; this strategy can be beneficial if prices mean-revert. Research has shown that equal-weighted indexes historically outperformed their cap-weighted parent indexes. 2 1 While Health Care has traditionally been considered a relatively defensive sector, it has become more dynamic in recent years as a result of growth in the biotechnology industry, legislation such as the Affordable Care Act, and other market forces. 2 Treynor, J. (25), Why Market-Valuation-Indifferent Indexing Works, Financial Analysts Journal, Vol. 61 (5), 65 69; Velvadapu, P. (21), The Russell Equal Weight Indexes: An enhancement to equal weight methodology, Russell Research. Russell Investments // The Russell 1 Equal Weight Sector Indexes: A simple and effective smart beta approach

2 Russell equal-weight indexes Russell Investments equal-weight indexes, introduced in 21, were designed to reduce the potential for sector biases in existing equal-weight indexes by use of a unique methodology that first equal-weights economic sectors and then equal-weights stocks within those sectors, and by rebalancing back to target weightings on a quarterly basis. 3 luded in the Russell series are U.S. large cap (Russell 1) equal-weight individual sector indexes that can provide a way for market participants to gain broadly diversified exposure across a single economic sector. This has historically had a meaningful effect in some of the more dynamic sectors, such as Technology, Health Care, Producer Durables and Consumer Discretionary. Technology sector The Technology sector is one of the more dynamic sectors, with tremendous innovation driving periods of rapid growth for some companies and industries. For example, the development of the Internet in the late199s was a period of strong growth and significant spikes in the prices of dot-com companies and other technology firms stocks. Many of these stocks rose to unsustainably high valuation levels, which declined dramatically when the dot-com bubble burst. Because a significant increase in its price also increases the weighting of a stock in a cap-weighted index, such indexes can experience significant short-term movement upward and downward as the gains and losses of a few large companies inflate and then deflate market bubbles. Equal-weighted indexes are less influenced by this type of momentum. In recent years, Apple. has come to dominate broad market indexes as well as Technology sector indexes, due to its rapid growth on the back of product innovations such as the iphone and ipad. As illustrated in Figure 1, Apple alone represented nearly 18% of the cap-weighted Russell 1 Technology Index as of June 3, 214. That of course means that the index s performance rests largely on Apple s fortunes, performing strongly when Apple advances and weakly when Apple declines. By contrast, the Russell 1 Equal Weight Technology Index takes a more broadly diversified stance, with performance relying not just on a single company or a few companies, but spread evenly across all index constituents. Figure 1: Technology sector top 1 holdings (as of June 3, 214) 18% % Apple Microsoft International Business Machines Google Google Class C, Intel QUALCOMM Oracle Facebook Cisco Systems Russell 1 Technology Index Russell 1 Equal Weight Technology Index 3 For further information about the Russell Equal Weight Index methodology, see the Russell Global Indexes Construction and Methodology document available at russell.com/indexes. Russell Investments // Russell 1 Equal Weight Sector Indexes: A simple and effective smart beta approach / p 2

3 7/1/1996 6/3/1997 6/3/1998 6/3/1999 6/3/2 6/3/21 6/3/22 6/3/23 6/3/24 6/3/25 6/3/26 6/3/27 6/3/28 6/3/29 6/3/21 6/3/211 6/3/212 6/3/213 6/3/214 Growth of $1 The way concentration can affect performance is illustrated in Figure 2. The cap-weighted Russell 1 Technology Index benefited during the late 199s boom as stock-price gains caused large companies to grow larger. However, the index also declined rapidly during the bust. By contrast, the Russell 1 Equal Weight Technology Index saw less of a run-up during the boom, but also a smaller peak-to-trough decline in the aftermath. Over the period shown July 1, 1996 to Dec. 31, 214 the equal-weight index delivered a comparable cumulative total return, but with moderately lower volatility. Figure 2: Technology sector performance chart (July 1, December 31, 214) Russell 1 Equal Weight Technology Index Russell 1 Technology Index Health Care sector As Figure 3 shows, the Russell 1 Health Care Index is dominated by several large pharmaceutical companies, such as Johnson & Johnson, Pfizer, and Merck. Together, these three firms represented approximately 25% of the cap-weighted index at June 3, 214. As in the Technology sector index, performance in the Health Care sector index is highly dependent on a few large firms. Less influential are potentially more dynamic younger firms, such as the biotech company Pharmacyclics, with a weighting of about 1% in the equal-weight index vs. just.21% in the cap-weighted index. By spreading exposures evenly across all companies in the sector, the Russell 1 Equal Weight Health Care Index is positioned to benefit equally regardless of which companies are driving performance. Figure 3: Health Care sector top 1 holdings (as of June 3, 214) 1 1 8% Johnson & Johnson Pfizer Merck & Co Gilead Sciences AbbVie Amgen Bristol- Myers Squibb Co UnitedHealth Biogen Idec Group Celgene Russell 1 Health Care Index Russell 1 Equal Weight Health Care Index Russell Investments // Russell 1 Equal Weight Sector Indexes: A simple and effective smart beta approach / p 3

4 7/1/1996 7/1/1997 7/1/1998 7/1/1999 7/1/2 7/1/21 7/1/22 7/1/23 7/1/24 7/1/25 7/1/26 7/1/27 7/1/28 7/1/29 7/1/21 7/1/211 7/1/212 7/1/213 7/1/214 Growth of $1 In the Health Care sector, the performance difference between the cap-weighted and equal-weight indexes was more pronounced than in the Technology sector, as illustrated in Figure 4. In Health Care, the capweighted index moved generally sideways from July 1996 to July 29, with a solid advance since then. By contrast, the equal-weight index moved more steadily higher over the period, with a stronger advance during the recovery following the 28 to 29 financial crisis. For the full period, the equal-weight index delivered nearly double the return of the cap-weighted index. Figure 4: Health Care performance chart (July 1, December 31, 214) Russell 1 Equal Weight Health Care Index Russell 1 Health Care Index Producers Durables sector As with the Health Care sector, the Russell 1 Producer Durables Index is dominated by a few large old industrial companies. As illustrated in Figure 5, General Electric held a nearly 1 weighting in the capweighted index as of June 3, 214. Along with United Technologies, 3M, Boeing and Union Pacific each with an approximately weighting the five largest companies represented about 25% of the index. Figure 5: Producer Durables sector top 1 holdings (as of June 3, 214) 1 1 8% General Electric Co United Technologies 3M Co Boeing Co Union Pacific Honeywell International United Parcel Service Caterpillar Accenture PLC Danaher Russell 1 Producer Durables Index Russell 1 Equal Weight Producer Durables Index Russell Investments // Russell 1 Equal Weight Sector Indexes: A simple and effective smart beta approach / p 4

5 7/1/1996 7/1/1997 7/1/1998 7/1/1999 7/1/2 7/1/21 7/1/22 7/1/23 7/1/24 7/1/25 7/1/26 7/1/27 7/1/28 7/1/29 7/1/21 7/1/211 7/1/212 7/1/213 7/1/214 Growth of $1 In the Producer Durables sector, the equal-weighted index also meaningfully outperformed the capweighted index over the period examined, benefiting from larger exposure to stronger performers. For example, Towers Watson held a weighting of.29% in the cap-weighted index vs. about 1% in the equalweight index as June 3, 214. Over the period July 1, 1996 to Dec. 31, 214, the equal-weight index delivered an approximately 5 greater cumulative total return, as illustrated in Figure 6. Figure 6: Producer Durables performance chart (July 1, December 31, 214) Russell 1 Equal Weight Producer Durables Index Russell 1 Producer Durables Index Consumer Discretionary sector The largest firms in the Russell 1 Consumer Discretionary Index are a mix of older firms such as Walt Disney and McDonald s and newer dynamic companies such as Amazon.com and ebay, as shown in Figure 7. However, the index is still concentrated such that nearly a quarter of its weighting is in the top five companies. Many dynamic retail and leisure companies, such as Dick s Sporting Goods and Expedia, have little influence on the performance of the cap-weighted index, due to their weightings of just a few basis points. Figure 7: Consumer Discretionary sector top 1 holdings (as of June 3, 214) 5% 3% 1% Walt Disney Co Comcast Amazon.com Wal-Mart Stores Home Depot McDonald's Ford Motor Co 21st Century Fox ebay The Priceline Group Russell 1 Consumer Discretionary Index Russell 1 Equal Weight Consumer Discretionary Index Russell Investments // Russell 1 Equal Weight Sector Indexes: A simple and effective smart beta approach / p 5

6 7/1/1996 6/3/1997 6/3/1998 6/3/1999 6/3/2 6/3/21 6/3/22 6/3/23 6/3/24 6/3/25 6/3/26 6/3/27 6/3/28 6/3/29 6/3/21 6/3/211 6/3/212 6/3/213 6/3/214 Growth of $1 This more broadly diversified exposure of the Russell 1 Equal Weight Consumer Discretionary Index led to higher cumulative total returns for the equal-weight index in the Consumer Discretionary sector as well. Over the period July 1, 1996 to Dec. 31, 214, the equal-weight index delivered an approximately 5 greater cumulative total return, as illustrated in Figure 8. Figure 8: Consumer Discretionary performance chart (July 1, December 31, 214) Russell 1 Equal Weight Consumer Discretionary Index Russell 1 Consumer Discretionary Index Conclusion Equal-weight indexes represent a simple way to implement an index-based strategy while avoiding some of the concentration inherent in market-cap-weighted indexes, where a few large companies in a sector can dominate index performance. Equal-weight sector indexes take this strategy a step further and enable market participants to gain broadly diversified exposure across sectors by allocating evenly across index constituents. Since equal-weight indexes are agnostic as to which factors are driving returns, they offer investors the potential to benefit from market inefficiencies by spreading constituent exposures evenly across an opportunity set and because these indexes break the link between a stock s price and its weight in an index, investors are not required to take a view on which factors will drive returns going forward. While equal-weight indexes might outperform or underperform their cap-weighted counterparts at any given time, research has shown that they can outperform over time. In some of the more dynamic economic sectors, equal-weight strategies have historically benefited from broad diversification and systematic rebalancing. Russell Investments // Russell 1 Equal Weight Sector Indexes: A simple and effective smart beta approach / p 6

7 About Russell Indexes Russell s indexes business, which began in 1984, accurately measures U.S. market segments and tracks investment manager behavior for Russell s investment management and consulting businesses. Today, our series of U.S. and global equity indexes reflect distinct investment universes asset class, geographic region, capitalization and style with no gaps or overlaps. Russell Indexes offers more than three dozen product families and calculates more than 7, benchmarks daily, covering 98% of the investable market globally, 81 countries and more than 1, securities. As of December 31, 213, approximately $5.2 trillion in assets are benchmarked to the Russell Indexes. For more information about Russell Indexes, call us or visit Americas: ; APAC: ; EMEA: Disclosures Russell Investments is a trade name and registered trademark of Frank Russell Company, a Washington USA corporation, which operates through subsidiaries worldwide and is part of London Stock Exchange Group. Russell Investments is the owner of the trademarks, service marks and copyrights related to its respective indexes. Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance and are not indicative of any specific investment. Unless otherwise noted, the source for the data in this report is Russell Investments. Indexes are not managed and cannot be invested in directly. This material is proprietary and may not be reproduced, transferred or distributed in any form without prior written permission from Russell Investments. It is delivered on an as is basis without warranty. This is not an offer, solicitation or recommendation to purchase any security or the services of any organization. Copyright Russell Investments 215. All rights reserved. First use: February 215. CORP Russell Investments // Russell 1 Equal Weight Sector Indexes: A simple and effective smart beta approach / p 7