Pumping Up Index Fund Returns

How can 2 index funds composed of the same constituents perform significantly differently? It is possible, and investors can use this strategy to enhance earnings.

For some time, investment managers have been concerned about index funds that are entirely capitalization weighted (also known as market-value weighted), where larger companies are given more weight and smaller companies less. The S&P 500, NASDAQ, Wilshire, Hang-Seng, and EAFE indexes are all weighted in this way. For this reason, large price moves in the bigger companies can make an enormous difference in the overall index value.

Critics of the capitalization-weighted approach claim that using this method gives an inaccurate view of the market. Supporters say that big companies have the most shareholders and, thereby, deserve their current overweighed positions in the indexes.

Whatever the resolution of this issue, new index funds tracking the traditional S&P and Russell 1000 make it clear that equal versus capitalization weighted makes a difference, at least over the short term. If I were a betting person, I would say over the long term as well.

To attempt to pump up index returns, some fund managers are giving more weight to the smaller firms in the index. For example, the Guggenheim S&P 500 Equal Weight ETF, known as RSP, is composed of the 500 stocks of the S&P index, but weights them equally. Investors in this fund will experience a bouncier road than in the capitalization-weighted fund because there is greater representation of smaller stocks, which, traditionally, have more volatility. The reward is a potentially greater return due to the fact that smaller companies conventionally perform better than larger ones over time.

Over a 10-year period, the performance of the equal weight S&P Guggenheim fund RSP (in blue) has significantly outperformed the capitalization weighted S&P index fund SPY (in green). From Yahoo Finance.

In fact, this approach worked over 10 years since the inception of RSP. The fund had a dramatically enhanced performance over SPY, a capitalization-weighted S&P fund (see above). This was is in spite of the fact that RSP rebalances quarterly, which increases trading costs as well as tax consequences. SPY does not.

Additionally, RSP’s annual expense ratio is 0.4% rather than the lower 0.09 for SPY. All of these costs for RSP cut into any profit, but its performance was able to exceed them. The fund also has a higher beta (a measure of risk) than the capitalization-weighted SPY, meaning it will have more volatility.

This equal-weighted approach is used with other funds, too (see below). The Power Shares FTSE RAFI US 1000, known as PRF, is composed of large- and mid-capitalization US equities that track the Russell 1000 but weights them equally. Its comparison, IShares Russell 1000, known as IWB, does the same but capitalization weights them. When compared over the last 8 years, since the inception of PRF, the equal-weighted PRF has an edge like RSP, but less so. The trading costs, tax consequences, expense ratio, and beta plus volatility of PRF are similar to RSP.

Over an 8-year period, the performance of the equal-weight Power shares FTSE RAF (in blue) has somewhat outperformed the capitalization-weighted IWB (in green). From Yahoo Finance.

Whether or not equal-weighted index funds will continue to enhance investor’s earnings over time is a question that no one can answer. Nevertheless, the evidence so far, plus logic, suggests that they will.