BOSTON – Exchange-traded funds that invest in widely-held S&P 500 companies can look markedly different, depending on how much they allocate to individual stocks.
The Rydex S&P Equal Weight ETF (RSP) invests the same amount — 0.20 percent — in every stock in the S&P 500 index (SPX), rebalancing quarterly to maintain the portfolio.
The specialized ETF “gives you diversification within diversification,” said Steve Sachs, director of trading at Rockville, Md.-based Rydex Investments. “You’re starting out with the same 500 names, but you’re spreading out the individual weightings.”
Most S&P 500 index funds and ETFs are so-called market capitalization-weighted, meaning a stock’s importance to the fund depends on its size — specifically, the stock price multiplied by the total number of shares outstanding.
About 20 percent of the assets in the largest U.S. exchange-traded fund, the S&P 500-tracking SPDR Trust (SPY), are concentrated in the largest names in the index, giants like General Electric (GE), ExxonMobil Corp. (XOM) and Microsoft Corp. (MSFT).
Unequal returns
An equal-weight fund holds the same companies as its market-weight counterpart, but its alternative strategy results in a portfolio that differs substantially in the size, valuation and sector allocation of its investments.
With small-cap stocks outperforming their larger peers in the market recovery of the past three years, the equal-weighted version of the S&P 500 has pulled ahead of the traditional version because it emphasizes smaller stocks in the benchmark.
Over the past five years as of Jan. 31, the equal-weighted S&P 500 has delivered annualized gains of 8.7 percent, compared with a loss of 1.8 percent per year for the market-weighted index, according to S&P Indexes.
“Small-caps have led the market the past few years after the unwinding of the overvaluation of the largest companies in the S&P 500 in the late 1990s,” said J.D. Steinhilber, head of advisory firm Agile Investing, which focuses on all-ETF portfolios.
The Rydex S&P Equal Weight, which launched in April 2003, has a one-year return of 11.6 percent through Feb. 23, or 4.4 percentage points better than the S&P 500, according to investment research firm Morningstar.
That outperformance has attracted considerable interest in the young ETF, which saw assets grow by $541.4 million to $765.9 million in 2004, a 242 percent increase, Rydex said.
However, markets tend to move in cycles, and many analysts are calling for large-caps to take the leadership baton again in 2005.
The equal-weighted Rydex ETF “has more of a bent to value and small-caps, so it’s had a lot of tailwind and that may not necessarily continue in the future,” said Dan Culloton, analyst at Chicago-based Morningstar.
“If large-caps take their turn in the near future then this fund will likely underperform the market cap-weighted S&P 500,” he added.
The fund’s higher fees could be a drag on returns — the equal-weighted ETF has an expense ratio of 0.40 percent, four times the 0.10 percent charged by the SPDR Trust.
Still, the ETF sports much lower fees than the B shares of Morgan Stanley Equally-Weighted S&P 500 fund (VADBX), which has an expense ratio of 1.63 and a 5 percent deferred load, according to Morningstar.
Variation on a theme
The equal-weighted ETF is reminiscent of the first index fund introduced in the early 1970s, which was designed to hold an equal amount of about 1,500 stocks listed on the New York Stock Exchange.
Although appealing in theory, execution was difficult. The enormous amount of trading required to maintain the equal weighting resulted in capital gains distributions and transaction costs.
The ETF format alleviates the tax inefficiency because of its unique creation and redemption process, said Rydex’s Sachs. The Rydex ETF has not issued capital gains distributions since inception, he added, despite its 55 percent portfolio turnover last year.
Meanwhile, the S&P 500 had turnover of 3.1 percent in 2004, according to S&P.
Aside from the equal-weighted fund’s higher turnover, it’s important for investors to realize what they’re getting with this ETF’s somewhat quirky approach, said Steinhilber, the financial adviser.
He points out the median market cap for the S&P 500 is $10 billion, a point some managers use as a dividing line between large-cap and midcap.
“So you end up with an index where an index where half of the companies are midcap or smaller by some definitions,” Steinhilber said.
“A lot of people assume all the companies in the S&P 500 are big companies, but that’s not the case,” he added. “There are some companies in the index with market capitalizations under $1 billion.”
By John Spence
Source: Investor’s Business Daily
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