The distribution of individual stock returns is not normal. A new research paper from VanEck reveals that the distribution of individual stock returns is “skewed” or pushed to one side, with only a few outperformers to the right.
The important point for investors is that they should aim to get meaningful exposure to this right-hand side of the distribution curve where the winners sit. An equal weight index achieves this better than a market capitalisation index.
The VanEck research paper reveals that a few select stocks contribute most of a total stock market’s returns and it is smaller sized companies that can deliver the greatest boost. The key reason an equal weight index outperforms a market capitalisation index is that it captures more of these returns.
The evidence to support this is cited in the research paper, which finds that since its inception in 2014, Australia’s standard equal weighted index, the MVIS Australia Equal Weight Index, has outperformed Australia’s standard market capitalisation weighted index, the S&P/ASX 200 Index Accumulation (S&P/ASX 200).
The evidence to support skew
Equal weighting a portfolio outperforms its market capitalisation counterparts over the long term and most short-term periods – and this holds true in Australia and in share markets around the globe.
The following analysis uses a data set of the 200 largest companies on the ASX at 12 May, 2015 and the returns they each generated over the following three years.
The distribution of returns is clearly skewed to the left. Chart one shows this data as a histogram, with the returns rounded to the nearest 10 per cent.
For the curious, the two bottom performers in the Australian data were Arrium and Slater & Gordon. The two top performers were BlueScope Steel and Regis Resources. A steelmaker at each end.
Chart one reveals:
- The lower-returning groups are bunched together on the left-hand side. One of the reasons for this is that stocks cannot lose more than 100 per cent, while the upside potential is unlimited;
- The peak is way to the left. Many stocks have relatively low returns; and
- The tail to the right is very long. A small number of stocks have a very high return.
The average return in this data set is 34 per cent, well above the median of 21 per cent which itself is well above the peak of the histogram at 10 per cent.
Returns for the 200 Largest Australian Stocks, Three Years to May 2018
Source: Bloomberg, VanEck
The figure below shows the imbalance of the skewed distribution visually. The return of each of the 200 largest ASX stocks is charted in numerical order. Stock 101 is marked to indicate the start of the top half.
It can be seen from chart two that there is more blue from stock 101 up than there is below that mark. The observations to be made here is that the right-hand side outweighs the left-hand side.
Returns for the 200 Largest Australian Stocks in Numerical Order, Three Years to May 2018
Source: Bloomberg, VanEck
The average return is higher than the median and the median is higher than the return at the centre. This is why a skewed distribution gets more benefit from its exposure to the right-hand side than detriment from exposure to the left-hand side.
Smaller versus larger stocks
The next insight from the data is that smaller stocks are more likely to be at the extremes of the skewed distribution. The figure below plots the returns against the stock’s market capitalisation at the beginning of the period.
It can be seen that the companies that were the largest at the beginning of the period produced returns that are far more narrowly distributed than the rest of the stocks. The extremes are populated by smaller stocks.
Mega sized stocks do not appear to be at the extremes of the skewed distribution. The twelve large cap stocks have a performance range of -36 per cent (Telstra) to 107 per cent (CSL) compared to the complete range of -100 to 416 per cent.
The better performance of the smaller stocks can be seen from the fact that the average for the smaller stocks is higher than the average for the large stocks.
This finding that the smaller stocks outperform the large stocks immediately explains the consistent outperformance of equal weighting over market capitalisation weighting. Equal weighting has consistently given greater exposure to the smaller stocks than market capitalisation weighting does. Market capitalisation favours big stocks, whose returns on average are not as high. The benefit of equal weighting is capturing greater returns through exposure to smaller stocks.
Implication for Australian investors
Not all equal weight approaches are equal. There needs to be a strong emphasis on liquidity and coverage which will help mitigate unnecessary tail risk. The MVIS Australia Equal Weight Index has outperformed the S&P/ASX 200 over most periods since its inception in 2014 because of its consistent exposure to these high performing smaller stocks.
VanEck’s belief in an equal weight approach led to the launch of the VanEck Vectors Australian Equal Weight ETF in March 2014. The ETF has outperformed the S&P/ASX 200 by 3.55 per cent per annum since its inception.
Michael Brown is VanEck's director - Asia Pacific.