Wednesday, December 28, 2011

Model Free Investing (Equal weight vs cap-weighted) RSP

RSP is the symbol for the Rydex Equal Weight S&P 500 ETF.
I owe someone a hat tip on this but can't remember who although I'm guessing it was Abnormal Returns.
From Financial Advisor:
Is equal weighting’s agnostic view of asset-pricing theory an advantage?
By James Picerno   
Financial journalist Jason Zweig once asked Harry Markowitz how he manages his investment portfolio. “My intention,” he explained, “was to minimize my future regret. So I split my contributions 50/50 between bonds and equities.”

Why would the founding father of modern finance choose a naïve strategy of equal weighting over his own theory for designing portfolios? Markowitz won a Nobel prize for his quantitative framework that identifies the optimal portfolio—the one that maximizes expected return for a given level of risk. Perhaps his choice of portfolio strategy has something to do with the fact that his analytic brainchild is highly sensitive to the accuracy of the required forecasts of returns, volatility and correlations.

No wonder that the true efficient portfolio is the stuff of dreams. Mere mortals have trouble estimating the parameters that lead to optimization because the future is forever murky. What looks like an efficient portfolio on the computer screen has a habit of delivering sub-optimal results in practice.

Markowitz’s plug for equal weighting suggests that he’s well aware of the practical limitations that bedevil his famous theory. That’s no slur on his achievements, which are rightly extolled as the seminal development in lifting finance out of the dark ages. The fundamental advice in his seminal 1952 paper (and the more elaborate book-length treatment that followed in 1959) is still correct: Every investor should seek the ideal asset mix. The debate is over the details for pursuing that goal.

Modern software packages and various enhancements to Markowitz’s original framework can help smooth the rough edges. But the inherent dangers of forecasting aren’t so easily engineered away. In search of guidance, investors have long turned to asset-pricing models of one kind or another. The standard choice is the capital asset-pricing model (CAPM), in part because of its simplicity. CAPM reduces the complexities of finding Markowitz’s optimal portfolio to a simple idea: Buy the market. According to the one-factor CAPM, the efficient strategy is the value-weighted portfolio of all the securities in the targeted asset class (or all the asset classes for a broad asset allocation strategy)....MORE 
Earlier this month The Economist's Buttonwood's Notebook blog also looked at the little beasties
Equity investing
Should we give equal weight to equal-weighted indices?
A HEADLINE on Bloomberg claims (in typical Bloomberg-ese) there was "No Lost Decade for S&P 500 as Big-Cap Bias Masks Rally". The idea is that, if you equally weight stocks, then they have risen 66% over the last decade.

That may be true and I have argued in the past that there's a lot of scope for alternative ways of weighting portfolios than market values. The Robert Arnott approach, which weights stocks by "fundamentals" like sales and dividends, avoids the peril of market-value weighting, which leads investors to allocate most money to those stocks that are most fashionable, and thus likely to be too expensive.

The problem with this approach is that, by definition, not all investors can follow it. If we all equally weighted stocks then, well, all stocks would be equally-weighted. As it is, many stocks are quite small and illiquid so are difficult for big managers to own. Take the Fidelity Magellan fund which had $100 billion at its peak; divided equally among 500 stocks, that would be $200 million per holding. For the smaller stocks, the fund would have 20% of the equity; as it got in and out, it would move the price substantially....MORE