An Easy Way to Beat the S&P 500

Jordan is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Beating the market isn't easy, but one very simple strategy outperforms year after year. It has nothing to do with market timing or leverage, nor do investors need to actively hunt down stocks.

Most funds are market-cap weighted, so they own more of bigger companies than smaller companies. A small tweak to the weighting can have a pronounced effect on a fund's performance. Equal-weighted funds set all stocks as equal parts of a portfolio, tipping the balance more toward smaller, faster-growing stocks than a market cap-weighted fund would.

All stocks are not created equal

The S&P 500 index (NYSEMKT: SPY) is a market cap-weighted index, meaning that it holds its largest positions in the companies with the largest market value. For instance, Exxon Mobil is the largest company on the U.S. public stock markets, and thus it is the largest component of the S&P 500 index at 2.79% of assets. AutoNation is currently the smallest company in the S&P 500, making up just 0.01% of the index.

Market-cap weighting creates many distortions. First, the obvious: The performance of Exxon Mobil has 279 times more impact than the performance of AutoNation, both of which are S&P 500 components.

Second, market-cap weighting results in buying high and selling low. As a company gains in value, S&P 500 trackers buy more shares to adjust for the market-cap weighting. When companies fall in value, S&P 500 trackers sell the stock at lower and lower prices. Chasing winners and selling temporary losers isn't exactly a strategy for success.

An alternative strategy

Equal-weighted portfolios are the most robust alternative to market-cap-weighted portfolios. An equal-weight portfolio weights all stocks equally, placing 2% of its assets in all 500 components of the S&P 500. Thus, small or large, the initial movements of a smaller S&P 500 component have just as much impact on performance as the movements of a megacorporation like Exxon Mobil.

Over time, the equal-weight strategy has consistently outperformed the market average, even though equal-weighted funds are more expensive to hold.

The Rydex S&P Equal Weight ETF (NYSEMKT: RSP) is an equal-weighted S&P 500 index ETF that invests equally among all stocks in the S&P 500 index. Since inception, the fund has significantly outperfomed despite costlier management fees (0.40% vs. 0.05% for the least expensive S&P 500 fund for which data is available, the iShares Core S&P 500 ETF (NYSEMKT: IVV)).

<table> <tbody> <tr> <td><strong>Period</strong></td> <td><strong>Equal Weight</strong></td> <td><strong>Market Cap Weight</strong></td> </tr> <tr> <td>1-Year</td> <td>32.33%</td> <td>25.78%</td> </tr> <tr> <td>3-Year</td> <td>61.23%</td> <td>57.72%</td> </tr> <tr> <td>5-Year</td> <td>49.26%</td> <td>31.81%</td> </tr> </tbody> </table>

A comparison of one-, three-, and five-year total performance shows the extent to which this strategy can best the market. All dividends and fees are included in this comparison of performance.

What investors give up

To be fair, investors have to relinquish something for consistent, market-beating performance.

First, equal-weight funds offer lower dividend yields, since they are invested more heavily in growing mid-cap companies. The Rydex equal-weight fund yields just 1.3%, compared to 1.9% for the market-cap-weighted S&P 500.

(Investors who want equal-weighted funds and dividends aren't left out completely. The ALPS Sector Dividend Dogs ETF (NYSEMKT: SDOG) yields 3.9% with an equal-weight strategy based on the 50 highest-yielding S&P 500 stocks.)

Second, equal-weight funds are slightly more volatile than the broader stock market. A historical, 10-year chart showcases the added volatility:

<img alt="" src="" />

SPY data by YCharts

While Rydex's equal-weight product pulled ahead for all periods during the last 10 years, higher returns over a market-cap-weighted fund were nearly erased during the 2009 financial crisis. Performance since the crisis has been nothing but stellar.

History doesn't lie. An equally weighted S&P 500 index propels investor performance by moving oppositely of market cap weighted funds, buying losers and selling winners to derive long-term outperformance. I'm initiating a CAPS long on Rydex's equal weight fund, as it should deliver above-market returns for long-term investors. 

Those who can tolerate lower current yields and slightly higher volatility should opt for equal-weight funds over their market-cap-weighted peers. 

Jordan Wathen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

blog comments powered by Disqus