Investors seeking better returns from the stock market might want to change their definition of it.
The Standard & Poor's 500-stock index -- "the market" to many investors -- must climb another 16% to top its October 2007 all-time high. But the S&P 500 Equal Weight index, which tracks the same companies, hit a new high last May and is only a few percentage points away from hitting another.
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Both indexes track the largest companies in America by stock market value, but the 500 index gives the largest companies more weighting. Its 10 largest companies make up nearly 20% of the index, and the percentage varies over time. In the equal weight index, the 10 largest companies consistently make up about 2% of the index.
Both indexes serve as the basis for passive mutual funds designed to track the market. Which is better? That depends on the goal.
If the goal is to maximize returns, the equal weight index has a more impressive record. Over five years through 2011, it returned 1.75% a year, versus a loss of 0.25% a year for the regular 500. And while the equal weight index was introduced only in January 2003, had it existed earlier it would have returned 10% a year over two decades through 2009, versus 8.2% for the regular 500, according to S&P research.
That's roughly the difference between turning $10,000 into $48,000 and turning it into $67,000, not adjusted for inflation, taxes or fees.
If the goal is to keep risk low, the choice is less clear. The equal weight index has a smaller average company size. That can juice returns, but small companies are generally considered riskier than large ones. A statistical measure called standard deviation, which shows how wildly prices have swung, suggests the equal weight index has been more volatile over the past five years. Not by much, however.
The 500 index tends to offer more exposure to bubbles, because it gives stocks higher weightings as they become more popular with investors. That helped it outperform the equal weight index during the 1990s dotcom stock mania but underperform it for years after the bust.
Of course, the 500 index isn't designed to maximize returns or reduce risk; it's designed to reflect the market. Whether it does so well depends upon what an investor buys. Individual stock buyers tend not to weight their stocks by company size, so for them, an equal weight index might better reflect their choices.
But the 500 remains far an away the most popular choice for indexing, with $5.6 trillion in assets tracking it, or around $800 for each person on earth. One reason funds like it is liquidity; it's easy to sop up vast sums of investor cash when the bulk of it is going to shares of the giant companies that can best absorb it.
For investors who wish to defy common practise and try equal weight investing, choices include the Rydex S&P 500 Equal Weight (RSP), an exchange-traded fund, and Invesco Equally Weighted S&P 500, an open-end fund. Favor the Rydex fund; it has yearly expenses of 0.4%, whereas "A" shares of the Invesco fund cost a maximum of 5.5% up front and 0.56% a year thereafter.
That's one downside of equal weight investing: higher fees. The cheapest 500 index funds, offered by companies like Vanguard, Fidelity and Charles Schwab, have fees of 0.1% a year or less. Another downside is more turnover. The 500 index has just 2% turnover in an ordinary year, because it simply maintains positions as companies grow larger and smaller. The equal weight index tends to have more than 20% turnover a year, because it must constantly adjust positions to keep its equal weights. More turnover keeps fees higher, and results in higher taxes. Then again, even the equal weight index has much lower turnover than most actively managed mutual funds.
Finally, if the 500 index's tendency to chase bubbles up and back is a quirk, the equal weight index has a quirk of its own. It tends to overweight sectors that have many companies and underweight ones that have fewer. For better or worse, that means that at the moment it offers more exposure than the 500 index to consumer discretionary, financial and materials companies, and less exposure to technology, staples and energy.
So far this year, the equal weight index has returned 8.9%, versus 7.1% for the 500.
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