Since Facebook’s disappointing earnings release on July 25, the stock has lost 26% of its value. Meanwhile, the mid-July announcement by Netflix that it failed to reach its second quarter subscriber target has sent the stock down more than 12%. Furthermore, short interest in these stocks has risen to $35.6 billion (as of August 31) from $32.8 billion a month ago, further demonstrating the market’s bearish stance on these stocks. Despite these setbacks, the FAANG group (Facebook, Apple, Amazon, Netflix, and Google) have still driven the performance of the S&P 500 and many other indices during the bull market of the last nine years. Since these five behemoths currently make up nearly 13% of the S&P 500, what can investors do to capture the upside offered by these megacap stocks but still hedge themselves against potential downturns?
Equal-Weighted Indices Outperform Market Cap Weighting
Market-cap weighting creates momentum bias since winners get a larger weight, which then leads to concentration and a larger decline should these companies experience difficulties, which is what we have felt in the past few weeks. On the other hand, equal-weighted indices have the same constituents as their market-cap weighted counterparts, but by holding the same weight in each security, they are hedging the concentration issue and increasing exposure to small-cap stocks.
Increased exposure to smaller caps is not free of risk, however, as smaller companies tend to be riskier than larger, more established ones. Despite this, equal-weighted indices tend to perform better than their market-cap weighted counterparts over the long term. As shown in the charts below, however, this trend does seem to have tailed off in the past 7-8 years, as the performance spreads started to flatten or even decrease in the case of the MSCI ACWI and S&P 500 equal-weighted indices.
Performance of MSCI World EW vs MSCI World
Performance of S&P 500 EW vs S&P 500
Performance of MSCI ACWI EW vs MSCI ACWI
What else can investors do to capture the diversification of equal-weighted indices and further protect themselves against potential downturns by FAANG stocks?
By “underweighting” larger cap securities, equal-weighted benchmarks would have missed out on some of the huge returns the FAANG stocks have experienced over the past few years (AAPL-US up nearly 618%, Facebook more than 350%, and Amazon more than 1300%). Therefore, could we keep the equal-weighting approach and apply a quality tilt in an attempt to capture the previous overperformance and protect ourselves from low-quality smaller cap stocks?
Our analysis will focus on the MSCI ACWI equal-weighted index. To find a way to protect investors against low-quality small caps, we set out to create a Quality factor using a mix of high profitability and low leverage characteristics based on fundamentals (seven factors in total):
These seven factors were z-scored, weighted, and combined to arrive at the final quality factor. This quality factor was then split into quintiles and backtested to see if there was any correlation between the stocks in the top quintiles and the highest performing stocks in the index. The returns spread between the different quintiles can be seen in the chart below.
The returns distribution is in line with expectations, with the first quintile performing better than the last quintile. The information coefficient (IC), which gives a concise measure of how well our quality factor is correlated with subsequent returns, stands at 0.05. The IC t-stat, which tells us how significant this figure is for the size of the population (68,815 over the period), is 2.48, indicating that our IC is statistically significant with a 99% confidence interval.
Since there seems to be correlation between our quality factor and stock returns, next we constructed a portfolio where we kept the best quality stocks, i.e. the stocks ranking in the first two quintiles of our quality factor within the lowest market caps (lowest 20%). We then calculated the performance of this portfolio over time versus the MSCI ACWI EW. In the chart below, we can see a clear outperformance of the “Quality” MSCI ACWI EW fund we created (nearly 47% overperformance over the period).
Furthermore, despite a spike in June/July 2013, in the chart below we can see that the total risk of our portfolio is consistently lower than that of the MSCI ACWI EW, our benchmark.
Based on our results, an equal-weighted alternative could be beneficial to investors to protect them against potential downturns in the FAANG stocks and megacaps at large. Furthermore, adopting a quality tilt to only capture the small caps with the highest quality fundamentals within this equal-weighted alternative can further improve performance and reduce overall risk. To further fine-tune our portfolio, we could potentially dig a little deeper and look at weighting securities based on their contribution to risk rather simply equal weighting all of them.
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