How to Beat the S&P 500

Can you really beat the S&P 500? Most professionals can’t; how can you? There is a fairly easy way to do it. You won’t beat it by much, but every little bit helps. And, you won’t have to pay too close attention to the stock market. If it’s easy to do and doesn’t take much time, why wouldn’t everyone do this?

Most people have no interest in closely monitoring their investing portfolio; they just want to set it and forget it. Maybe you’re one of those people who is willing to put in a little work and re-balance your portfolio on a period basis.

Beating the S&P 500 can be done simply by choosing an alternate fund. Further, you can improve those returns a little bit more if you are willing to trade in and out of a couple of funds.

Let’s assume that you are an indexer; you invest all of your money in index funds. You might have 33% in an S&P 500 index fund, another 33% in an international fund, and the remainder in a bond fund.

All of your funds are in index funds. All of your funds charge minuscule fees. As a broad market indexer, your investments will track the overall market. That is, you won’t out perform the market and you won’t under perform the market. You can’t; by definition, if you are investing in broad based funds, whatever the market does it what your portfolio does. If the market is up 15% one year, your portfolio will be up (roughly) 15% as well. Conversely, if the overall market is down 5% one year, your portfolio will also decline by about 5%. Whatever the market does, your portfolio will do.

With 500 individual holdings, the typical S&P 500 index fund, like the Spider fund (ticker symbol: SPY),offers a broadly diversified portfolio which offers the investor easy access to a wide variety of investments. You get the opportunity to invest in 500 individual companies and across many sectors of the market. The portfolio construction of typical S&P 500 funds might contain all 500 stocks in the S&P 500 , but not in equal proportions.

The SPY, like most S&P 500 funds, are structured based upon market cap. Market capitalization (or cap) is measured by multiplying the company’s stock price by the number of shares available. That is, the bigger a company is, the greater emphasis and impact it will have on the overall fund’s performance. The largest companies in the S&P 500 are all household names: Apple, Microsoft, ExxonMobil, General Electric, Johnson & Johnson, and Wells Fargo, just to name a few. These largest components of the S&P 500 have a much greater impact on the value of the S&P 500 index fund than smaller companies have on the index’s value.

risk-rewardThere is an S&P 500 index fund which is structured a little differently. The Guggenheim S&P 500 Equal Weight fund (ticker symbol: RSP) owns all of the stocks in the S&P 500 but as its name suggests, assigns equal weightings to them. That is it holds all 500 stocks in the S&P 500, but instead of assigning a market cap weighted approach where larger companies have a greater impact on the fund, it weights the 500 companies equally. The biggest difference is that smaller companies have the same impact on the fund’s performance as larger companies do. So instead of Apple, Microsoft, etc. having a larger impact on the fund’s performance, all companies have an equal weighting. This means that smaller companies have a larger impact on this fund’s performance than larger companies have on the S&P 500.

Essentially this increases this funds risk level, but with increased risk can come increased performance. The fund has outpaced the market-cap-weighted S&P 500 during the past 10 years. Over that time frame, RSP has outperformed SPY by about 1% annually. A 1% differential might not sound like much, but over an extended period of time, the difference can really add up. Simply stated, if you started out with $100,000 and your portfolio returned 8% annually, you would have over $466,000 after 2o years. (This assumes an 8% annual return, which has been typical of most S&P 500 cap weighted funds.) If you increased the annual return just 1% to 9% annually, your would likely have an a $100,000 after 20 years. As you keep adding money to your investments each year, the difference really starts to add up.

This 1% differential, while significant, is certainly not guaranteed, but over the past ten years, the Guggenheim S&P 500 Equal Weight fund has outperformed the typical cap-weighted index fund. Equal-weighting may also offer a slight improvement in return by systematically selling recent winners and buying recent losers when it rebalances. Rebalancing is something that many index investors do annually. The Guggenheim rebalances more often. This may give the fund greater exposure to stocks with low valuations relative to a market-cap-weighted alternative and addresses market-cap-weighting’s potential drawback of overweighting expensive growth stocks.

One larger potential disadvantage is the fund’s expense ratio. Typically, S&P 500 index funds have minuscule fees; oftentimes these fees are just 8 or 9 basis points (that’s 0.09%). But the Guggenheim fund charges 0.40%. These relative high fees and trading costs may erode the outperformance from the fund’s rebalancing strategy.

The Guggenheim fund rebalances its fund lineup much more often than a typical S&P 500 fund does. This trading activity is measured as the funds portfolio turnover ratio; the higher the ratio, the more trading (and therefore more expense) the fund incurs. The typical S&P 500 fund has a turnover ratio of just 2.77% while the Guggenheim fund has a turnover ratio of 18.00%

For those looking for dividends, the yield on the typical S&P 500 is slightly higher than the Guggenheim fund. The SPY is currently yielding 1.98% and the RSP is yielding 1.64%. This difference is directly attributable to the makeup of the fund. The TSP fund with its greater emphasis on smaller companies has a great portion of its portfolio in many companies which don’t offer dividends at all. All of the largest companies in a typical S&P 500 fund throw off dividends to their investors.

In summary, the outperformance of RSP is due to it taking more risks by investing in smaller companies. Will RSP continue to outperform SPY? The short answer is: probably, simply because more risk oftentimes means more reward. The increased annual return may well bear fruit over the long term, but of course, there is no guarantee. Is switching to RSP worth your while? If you are willing to take on additional risk, you might want to switch from the SPY to the RSP fund, but as always, the choice is yours.




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