A comparison between capitalization-weighted and equally weighted indexes in the European equity market

ABSTRACT This article aims at comparing two major equity index construction methodologies, the capitalization-weighted and the equally weighted approaches. Focusing on the constituents of the DJ Euro Stoxx index from January 2002 to December 2011, it provides further evidence to add to the established literature on this topic, of the higher risk-adjusted returns achieved by equally weighted portfolios in comparison with cap-weighted indexes. The novelty of our study is that we test these findings on the Euro stock market by using four reweighting frequencies (monthly, quarterly, semiannually and annually) with the aim of identifying that which is most able to maximize the benefits of the contrarian strategy implicit in the equally weighted approach. Moreover, it is demonstrated that the excess returns are not driven solely by a ‘size effect’ that usually explains the difference in performance of the two methodologies. Finally, we confirm our results by performing a Fama- French (1992) three-factor regression analysis and also by using a portfolio approach based on the market capitalization of the index constituents. To evaluate the implementation of the EW strategy, from an operational perspective, we estimate the related transaction costs and show that trading costs are not able to affect the main results.