Why Skillful Managers Prefer Equal-Weighted Benchmarks

Abstract

The author investigates the relationship between a manager's ability to add value and the way the relevant benchmark index is constructed. He first observes that the larger the number of securities in the index, the higher the potential for added value, as this permits bets with index stocks rather than requiring the manager to go outside the index's universe. Secondly, he argues that equal-weighted indexes are easier to beat, as, the weight of each stock in the index being the same, the manager has an equal opportunity to over- or underweight each stock. He goes on to argue that market capitalization weighted indexes, by contrast, make it harder to overweight larger stocks and underweight smaller stocks.