Diversified Equity Portfolios: The Case to Use Risk-Based Weights to Construct an Investable Equity Index

When making a passive equity investment investors typically use indexes that are weighted by the market capitalization of the constituents. Using S&P 500 US equity sectors I will show that market cap weights provide inefficient diversification. As an alternative to the market cap weighted S&P 500 index I will introduce an investable risk-based index using SPDR sector ETFs. The risk-based weights are calculated using a risk parity methodology and over the life of the portfolio (03-26-1999 to 02-28-2015) create a cumulative return net of estimated trading costs of 79.5% compared to the S&P 500 return of 55.9%1. In addition to its higher returns, the sector equal risk contribution portfolio (ERP) has lower risk measured by standard deviation, conditional value at risk, and drawdowns.