We’re big advocates of relative-strength weighting. That’s how our Technical Leaders Index is set up and it’s performed pretty well. Another common alternative is market capitalization weighting, which is the default method for most of the major indexes. A less common, but also robust, method is equal-weighting. With all weighting methods, volatility should be productive if there is some kind of rebalancing going on. The Technical Leaders Index is reconstituted and rebalanced quarterly to take advantage of relative strength trends, for instance.
Relative strength methodologies are quite volatile and weights rise with the trend. Cap weighting and equal weighting are typically mean reversion methods and weights rise against the trend. The Capital Spectator recently carried an article that showed just how productive volatility can really be. James Picerno, who edits The Capital Spectator, has a Global Market Index, which has as its components all of the major global asset classes. (You can click on the link in his article to see what they are. By the way, he has one of the finest blogrolls anywhere–full of great resources.)
In the chart below, the GMI is rebalanced just once a year, to market weights or equal weights, depending on the index.
Source: Capital Spectator (click on image to enlarge)
For most of the time frame shown, equal weighting outperforms. Equal weighting is completely naive. In effect you are saying, “I have no idea what will perform best, so I will just buy equal amounts of everything.” Fortunately, since—in truth—no one has any idea what will perform best, equal weighting works pretty well. Market weighting, if you believe the arguments put forward by Rob Arnott, suffers from overvalued assets getting large weights. In that sense, perhaps equal weighting is the purer approach.
Why are the rebalanced returns higher than the index returns? In a word, volatility. Regardless of the weighting method, rebalancing takes advantage of market volatility. Investors need to reframe the way they think about volatility. Volatility is not necessarily something negative or something to panic about. If it is harnessed, volatility can be the engine for higher returns.
