The yin and yang is a fundamental concept in Chinese philosophy. The idea is believed to be over 2,500 years old and appears in ancient Chinese texts like the I Ching, and throughout the philosophies and teachings of Taoism.
The duality of the yin and yang does not describe opposites. The two end-points of a flat line might be opposites, yin and yang aren’t that. Yin and yang are harmonious. Not really opposite, more like complementary. Balanced.
We experience yin and yang among the cycles of our emotions. In complementary relationships. The sun and the moon are yin and yang. The Jedi and the Sith. And so on.
And like all beautiful patterns, we find yin and yang throughout the markets. Particularly with the two forces of mean reversion, and momentum.
You can strip almost any investment strategy to it’s essence, distill it to it’s root alpha generating force, and that force can almost always be described as either a variation of mean reversion or momentum.
Passive investing, or more specifically, market cap weighted index investing, is a momentum strategy. Not to be confused with the momentum factor, or tactical funds, I am talking about what it really is at it’s core. In a market cap weighted index fund money is allocated to companies in proportion to their size. And as a stock grows, it’s proportion within the index grows. As the stock declines, so does it’s representation in the index. That, ladies and gents, is the force of momentum.
Equal weight is different. Not an opposite, exactly, but a yang to the yin. An equal weight strategy, when it outperforms, has two sources for that outperformance.
The first one is a size tilt. In a market cap weighted index, the mean size of the companies in the index far outweigh the median, since the bigger companies take a higher proportional weight. In an equal weight fund the mean equals the median. In other words, the weighted average size of the underlying companies drops significantly. And more often than not, smaller companies have performed better than large ones.
The second source of outperformance is more curious. It is the counter-weight to that force of momentum. Equal weight funds are essentially mean reversion funds. Here is how it works:
When an equal weight fund rebalances, all of the stocks have an equal weighting. And then, from that point until the next rebalance, some stocks go up and others go down. When the next index rebalance comes, the winners are sold back to parity, the losers are bought back to parity, and all weights are equal again. Mean reversion.
Momentum and mean reversion. Market cap weight and equal weight. Yin and yang.
My friend and colleague Hunter Hopcroft said something the other day that gave me an a-ha moment that I haven’t been able to shake. We were talking about how volatility is measured in real estate, and how absurd it is that the same property would have entirely different volatility characteristics depending on whether that property was packaged up inside a listed REIT, a private REIT, or sold independently as a standalone building.
Hunter said that because REIT securities themselves are more volatile than the real estate that those REITs are composed of, that should provide more opportunities for mean reversion.
Hmm.
And after he said that we both sat there for a minute and let it sit. And then, we feverishly started testing the thesis.
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Now I need to break character for a minute:
Long time readers of this blog know that this is a bit of a personal diary, and at times can veer far off of my professional course. And as my company, investment philosophies and funds themselves are such a large part of my life, there are times where this blog and my work will intersect. I must be careful, however, to respect the good folks in compliance and the well thought out fund company marketing rules, so we’ve set some hard lines of separation. Which is to say, I can not discuss our funds here without a rigorous proctology exam.
If you are interested in our research on equal weight and REITs or how we will be managing any of our funds I’d encourage you to sign up for our weekly REIT research newsletter at armadaetfs.com. You may find the second half of this story in your inbox this time next week.
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Such an abrupt ending to this post would be rude, so I’ll offer up another Taoist philosophy, which is the idea of Wu Ming, typically associated with ignorance or lack of enlightenment. This too shows up in markets, particularly in price weighted index investing. So the next time someone quotes you the Dow, remember the Tao
great take, thank you!
"The Jedi and the Sith."
Ah, my people.
Even among the Jedi and the Sith they have Master/Apprentice -- rule of 2 dynamics.
Yin and Yang WITHIN Yin and Yang.
Fractal Zen <--- that'd be a good SF valley Founder's only band name