The size factor in the mega cap year

• Equally weighted factor strategies consistently underweight large and mega caps.
• Market capitalisation weighted factor strategies show lower factor loadings and reduced relative risk.
• Controlled factor strategies achieve similar risk-adjusted returns long-term, regardless of weighting (information ratios).
   

Equal weighting vs market capitalisation weighting

In our recent Equity Insights (#30 & #31), we thoroughly examined the mega cap effect. Despite no significant influence over a long-term period of more than 20 years, recent years have seen a dis­tinctive, idiosyncratic mega cap effect in the global stock market. Even after controlling for all value-driving factors, this effect couldn't be substituted without impacting returns. 

A critical aspect in managing this idiosyncratic effect lies in the portfolio's weighting scheme, which determines the potential under or overexposure to mega caps. An equally weighted port­folio inevitably results in substantial underweighting of mega caps. Conversely, with a market capitalization weighted approach, the emphasis is on actively deviating from the original index weight, usually within ±1 percent in the Assenagon Equity Frame­work. This article compares these two weighting schemes and explores the considerations guiding their selection.

Examining the Size Factor

Given that the size factor is inherently most affected by the mega cap effect, since it emphasizes small and medium-sized compa­nies, we begin our analysis by focusing on this factor.

Figure 1 compares the relative performance of two controlled size strategies against the global equity market, differing solely in their respective weightings. Despite these differences, both portfolios actively deviate from the global equity market, only with regard to the size factor. All value-driving aspects, including country and sector allocation and other factor effects, are neu­tralized in comparison to the benchmark.

Within the Assenagon Equity Framework, this signifies complete independence of factor exposure from the weighting scheme. Consequently, even in a market capitalization-weighted portfolio, deliberate underweighting of large caps and overweighting of small and mid-caps can yield substantial size exposure, signify­cantly reducing relative risks within the large and mega cap sectors.

Fig. 1: Relative performance compared to the global equity market
(December 2022 – July 2023)

Indeed, in 2023, the underperformance of the size factor could be notably mitigated, though not entirely averted, by adopting a market capitalization-based weighting approach. While an equally weighted strategy for the size factor resulted in a -6% underper­formance compared to the global equity market in 2023, a long-term perspective presents a different picture. Over the past two decades, an equally weighted size strategy has significantly out­performed the market capitalization-weighted counterpart (see Figure 2).

Diversification, Active Share and Factor Characteristics

In Equity Insights #30, we emphasized the critical role of portfolio construction in diversifying individual stock risks extensively while steering clear of concentration risks. The objective is to ensure that controlled factor strategies, regardless of the applied weighting methodology, maintain at least the same diversification level as the underlying universe, assessed by the key metric "Effective Number of Constituents" (ENC).

Equal-weighted factor strategies, as previously mentioned, result in more pronounced over- or underweighting of individual stocks, thus fundamentally driving a higher active share compared to their market capitalization-weighted counterparts. Consequently, this leads to a notably amplified factor expression, fostering a more robust participation in the factor premium and a higher tracking error.

Fig. 2: Distribution of annual outperformance compared to the global equity market over rolling 3-year periods (January 2000 – August 2023)
 

Assenagon Equity Framework

Figure 2 illustrates the annual outperformance distribution rela­tive to the global equity market for both size strategies across rolling 3-year periods since January 2000. In both cases, a signi­ficantly positive factor premium is prevalent in the majority of periods. However, distinct differences emerge in the distribution pattern.

The higher active share and subsequent elevated tracking error of the equal-weighted size factor are evident at the edges of the dis­tribution. Instances of pronounced outperformance or underper­formance are notably more frequent compared to the market capitalization-weighted variant. This augmented tracking error is counterbalanced by a sustained long-term higher average pre­mium, resulting in a superior information ratio (outperformance/ tracking error), irrespective of the weighting approach. Unlike the equal-weighted factor, the market capitalization-weighted size factor operates within a more moderate range without such pronounced extremes, also with regard to the tracking error.

For the investor

Ultimately, the decisive factor in choosing a weighting scheme should be the attainable risk-return profile.

In the context of holistic portfolio construction, where the sole emphasis is on the pure factor premium as the principal value driver, there exists no significant disparity in the long-term infor­mation ratio between the presented variants. Therefore, the preferred option should align most closely with individual risk tolerance.

PS: Discover in the forthcoming issue how equal weighting and market capitalization weighting impact other factors.