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Buy the S&P 500 with better returns
Rydex S&P Equal Weight owns the same stocks as the S&P 500, but veers from the index's weighting system, which has allowed it to post better recent returns.
By Timothy Middleton
A Standard & Poor's 500 Index fund, the standard for many investors, has been a pretty lousy investment this year. There has to be something better.
In this market, there is. It's an exchange-traded fund called Rydex S&P Equal Weight (RSP, news, msgs) that strays a bit from the index. This year, as of Nov. 22, it's ahead 12%. The S&P 500 Spider (SPY, news, msgs), which strictly represents the index, is ahead 7.2%.
The Rydex fund owns exactly the same stocks as the index and the Spider, but the resemblance ends there. In the index, the biggest companies carry the most weight: Some 22% of its holdings are in just 10 stocks, including General Electric (GE, news, msgs), Exxon Mobil (XOM, news, msgs) and Pfizer (PFE, news, msgs). In the Rydex fund, those same stocks account for just 2% of assets. Each gets the same investment as vastly smaller companies in the S&P 500 like Goodyear Tire & Rubber (GT, news, msgs) and Winn-Dixie Stores (WIN, news, msgs).
"This is a poor man's value tilt," says Robert Deere, head of domestic equities for Dimensional Fund Advisors, the foremost operator of customized index funds for institutions.
DFA heavily favors small and downtrodden stocks, citing academic research that shows they outperform big-cap growth stocks over long periods. Since this fund does that implicitly, "I would expect it to give you a higher return -- no doubt about it," he says.
The drawbacks
By the same token, the fund won't outperform in a growth-stock rally such as that of 1999. Also, its operating expenses are much higher than rival index funds.
In today's market, however, the Rydex fund is clearly superior to any S&P 500 index fund.
S&P index funds were heavily sold in the late 1990s as a one-stop way to invest in stocks. In the '90s these funds outperformed nearly 80% of actively managed big-cap stock funds, thanks in part to minuscule turnover (2% for the Spider) and bare-bones annual operating costs (0.12%).
But in the bear market, investors discovered the weakness built into their design. For one thing, active managers could flee troubled companies, but indexers couldn't. Active managers also could seek out small companies and stocks at bargain prices, two areas the S&P 500 scarcely recognizes.
Since equities plunged into the worst bear market in modern history in 2000, small and value stocks have been the market's best bets. This year, according to Morningstar, 55% of equity mutual funds are beating S&P 500 mimic Vanguard 500 Index (VFINX), the largest mutual fund with nearly $80 billion of assets.
Rydex worked with Standard & Poor's to design the equal-weight fund. It allocates 0.2% of its assets to each of the index's 500 stocks. This automatically gives more weight to small companies, because they're more numerous; the average market cap of the Rydex fund is $8.79 billion, compared with $45.07 billion for the Spider.
Finding the sweet spot
Thus the fund is a mid-, rather than large-, capitalization portfolio, which many investors, including me, believe is the market's sweet spot. These are successful, established companies with a much lower failure rate than small caps.
Related ETF articles on MSN Money
They're often faster growing than the giants, as well. ExxonMobil (with a market cap of $329.15 billion) has grown sales at an average rate of 8.2% in each of the last five years; EOG Resources (EOG, news, msgs) ($8.77 billion), another energy company in the index, has grown them 15.2%.
If the share price of one of the companies in the index climbs sharply, the Rydex fund pares it down to a 0.2% weighting when the portfolio is rebalanced every quarter. If a stock tumbles, more is added. Thus the fund is continuously funneling profits from stronger to weaker issues; in effect, selling high and buying low.
Frequent rebalancing like this -- it amounts to an annual turnover rate of about 29% --would be a crushing burden for a mutual fund, because it radically raises trading costs and the likelihood of realizing short-term capital gains, which would have to be passed on to shareholders in the form of a taxable distribution.
Rydex insists that its exchange-traded fund avoids both of these problems. ETFs are created in round lots of all the stocks they own, and destroyed by exchanging them for the stocks themselves, not cash, at the institutional level. (Click here for a more detailed explanation of ETFs.) They're created and destroyed in response to market demand. Popular issues grow; unpopular ones wither. The Rydex fund is expanding; its assets currently are $645 million, up from $485 million earlier this year.
Buying cheap
Steve Sachs, Rydex's director of trading, says that when new units are created he buys fewer of the expensive shares, and more of the cheap ones, in an amount sufficient to bring the overall total for all ETF shares outstanding into the 0.2% range for each issue.
"This would be a nightmare to manage as a mutual fund," he says, "but the emergence of the ETF structure makes possible this in-kind (i.e., non-cash) transfer in the creation and redemption process. . . . What you have is an exchange of inventory, if you will, without having to go into the marketplace to buy and sell all the stocks in the portfolio."
The fund, which was launched in the spring of 2003, didn't make any capital gains distributions last year, and Sachs says it doesn't expect to make any this year.
The ETF's expense ratio is 0.4%. That's more than three times that of the Spider, eroding indexing's greatest advantage.
So Deere of DFA eyes the Rydex fund skeptically. He notes that it would be possible to exactly duplicate the structure of the Rydex fund with a basket of conventional index funds, including small and value funds as well as the S&P 500, with combined annual expenses significantly below 0.4%.
Indeed, in my model ETF portfolio I use iShares Russell 2000 (IWM, news, msgs) to represent small caps. Its expense ratio is 0.2%.
A big margin
Also, when big-cap growth stocks are flourishing, the index performs better than Rydex's fund. According to Rydex's research, if the fund had been operating between 1994 and 1999, it would have trailed the performance of the index every year, and by as much as 16 percentage points in 1998.
Despite this, Rydex says that the equal-weighted index has greatly outperformed the market-weighted index over the last 10 years, delivering annualized returns of 14%, compared with 12% for the index.
For that reason, and because I prefer the simple to the complex, this fund strikes me as a strong candidate for a long-term, buy-it-and-forget-it portfolio, such as a rollover IRA or child's education account.
Occam's razor is just as sound a principle in investing as it is in physics: If a thing can be simple or complicated, simple is better.
At the time of publication, Timothy Middleton didn't own any securities mentioned in this article.
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