Fama and french calculated value weighted portfolio return while framing SMB, HML and WML factor. But why not equal weighted portfolio returns because I think equal weighted portfolio have more diversification as compared to value weighted portfolio. Because value weighted portfolio is biased by giving more weight to large cap companies so the mean return are mostly driven by large cap. I also found one study which found equal weighted portfolio outperform price - weighted or value weighted portfolio. So can someone enlighten me which one to use while framing these factors.
It is generally believed that market capitalization-weighted portfolios, also known as cap-weighted portfolios, tend to outperform equally-weighted portfolios over the long term. This is because cap-weighted portfolios reflect the underlying market, whereas equally-weighted portfolios do not.
Market capitalization-weighted portfolios are constructed by allocating a larger portion of the portfolio to companies with a higher market capitalization (market cap). Market cap is a measure of the size of a company and is calculated by multiplying the company's stock price by the number of outstanding shares. Companies with a higher market cap are generally more established and financially stable than those with a lower market cap.
On the other hand, equally-weighted portfolios are constructed by allocating the same amount of capital to each company in the portfolio, regardless of the company's market cap. This means that smaller companies and larger companies are given the same weight in the portfolio.
One of the main arguments in favor of cap-weighted portfolios is that they tend to outperform equally-weighted portfolios over the long term. This is because they are more closely aligned with the underlying market and tend to benefit from the long-term growth of larger, more established companies. In contrast, equally-weighted portfolios may underperform due to the higher volatility and lower liquidity of smaller companies.
However, it is important to note that different investment strategies may be appropriate for different investors, depending on their individual risk tolerance and investment objectives. Before making any investment decisions, it is advisable to consult with a financial advisor or professional to determine the best strategy for your specific needs.
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