Worried about high valuations? Here's how using a low-cost active strategy can help.

Lately, there’s been a lot of buzz about the market, especially worries over high valuations. The Magnificent 7 stocks are holding a significant chunk of the market, and many are concerned that if these major players experience a downturn, it could bring more volatility to your portfolio.

To address this, an approach might be to diversify and rebalance your investments to lower the overall valuation. One way to do this is by exploring an equal-weighted S&P 500 fund instead of the traditional market cap-weighted S&P 500 index. To help you understand the potential benefits, let’s take a closer look at the historical performance of the S&P 500 from 1974 to 2019.

Exhibit 1 - Summary of Historical Performance, July 1974–December 2019

July 1974 - December 2019	Market Weight	Equal  Weight
Annualised Compound Return (%)	11.8	13.8
Annualised Standard Deviation (%)	15.5	19.9

Returns

From July 1974 to December 2019, an equal-weighted index simulation delivered impressive results, outperforming the traditional market with an average annual return of 13.8% compared to 11.8%. While these numbers show a stronger return, it's important to remember that higher returns aren't the only thing that matters—keeping risks in check is equally vital.

Risk Management

The equal-weighted portfolio is more volatile, with an average annual standard deviation of 19.9% compared to 15.5% for the market-weighted portfolio. This higher volatility occurs because equal-weighted indexes don't incorporate real-time information about individual companies or the broader market, leading to less effective risk control. 

For example, if some companies in the portfolio are heading towards bankruptcy, the equal-weighted approach continues to allocate the same weights to both struggling and profitable companies, increasing overall risk.

Costs

Equal-weighted strategies require frequent rebalancing, which results in much higher trading activity compared to the traditional market approach—about 32% versus 6% (refer to the  Exhibit 2). This increased trading means higher expenses, and those extra costs can eat into your overall returns.

There are three key differences between equal-weighted and market-weighted portfolios: equal-weighted portfolios often achieve higher returns, experience greater fluctuations in value, and incur higher trading costs compared to market-weighted portfolios.

So.. what is the solution?

We compare our low-cost core strategies with a focus on small-cap, value, and profitability within the same timeframe.

July 1974 - December 2019	Market Weight	Equal  Weight	Integrated Core
Annualised Compound Return (%)	11.8	13.8	13.5
Annualised Standard Deviation (%)	15.5	19.9	15.7

Returns & Risk Management

Our core strategy utilizes market prices to adjust the weights of securities, preventing extreme deviations and maintaining a balanced approach to over- and underweighting. From our observations, the core strategy not only delivers higher returns than the traditional market approach but also manages risk more effectively, achieving similar returns to the equal-weighted strategy with lower volatility.

Exhibit 2 - Average Annual One-Way Turnover by Strategy Weight, July 1974–December 2019

July 1974 - December 2019	Market Weight	Equal  Weight	Integrated Core
All	6%	32%	22%
Within Large Caps	6%	24%	22%
Within Small ex Micro Caps	9%	29%	20%
Within Micro Caps	11%	36%	21%

Costs

When it comes to costs, both the Equal-weighted and our Core strategy involve more trading activity than the market. However, our Core strategy has a lower turnover rate, which means you'll incur fewer trading fees overall.

Recent Observations

Another timeframe when technology company valuations were soaring spanned from 2000 to 2009, overlapping with both the dot-com bust and the global financial crisis. During this challenging period, we compared our Core strategy against the S&P 500 to assess performance and resilience.

Exhibit 3 - Performance, Monthly: 01/01/2000 - 31/12/2009

	Annualized Return (%)	Cumulative Return (%)	Annualized Standard Deviation (%)
S&P 500 Index	-0.95	-9.10	16.13
Dimensional US Adjusted Market Index	3.86	46.04	16.53

With $100,000 invested in our core portfolio from 2000 to 2009—it would have grown by 46%, reaching a total of $146,000. Meanwhile, the S&P 500 would have taken a hit, ending the decade with a loss of 9%.

In short, while passive index investing is certainly valuable, active strategies like ours offer significant benefits by helping investors achieve higher returns for each unit of volatility risk they take on.

This is an article by InvestAble.

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