Equal and Better

n April of 2003 Rydex introduced an exchange traded fund (symbol RSP) designed to track the S&P 500 Equal Weighted Index, or SPXEW. According to Rydex, the rationale for doing so is to provide investors "broad exposure to all companies in the S&P 500 Index, without the domination of a small group of stocks". A common concern relating to the well known and widely tracked S&P 500 Index (SPX) is its bias towards the largest companies within the index. This bias is the result of market capitalization weighting.

SPXEW has the same 500 constituents as the market cap weighted SPX, but each company is allocated a fixed weight of 0.20%. Compared to SPX, SPXEW will have higher exposure to firms with smaller market capitalization, lower exposure to mega-cap stocks, higher turnover due to quarterly rebalancing, different sector exposure, and different risk/return characteristics. This study examines just how different SPXEW has been compared to SPX over the past 16 years. (SPXEW performance data are available back to January, 1990 on the Standard & Poor's website).

In "More Return, Less Risk", the annual returns of the SPXEW and the SPX are shown side by side. The most striking initial observation is the cyclical performance pattern regarding which version of the 500 Index is performing better (shown by alternating color shading). In the early 1990s SPXEW generated higher returns. During the bull run (1994-1999) SPX outperformed SPXEW by nearly 650 basis points. Mega cap stocks were generally the best performers during this period and the SPX is much more sensitive to the performance of the largest companies. From 2000 through 2005 the SPXEW had a 6-year annualized return of 8.06% compared to -1.13% for the SPX. When the largest companies in the index falter, so does the SPX.

Over the 16-year period from 1990-2005, SPXEW's annualized return of 12.42% was 187 basis points higher than SPX. Moreover, the volatility of annual returns in SPXEW (as measured by standard deviation of annual returns) was 172 basis points lower than SPX. Advantage SPXEW.

Probing deeper, we observe that SPX had slightly higher average positive returns than SPXEW (19.79% to 19.01%). However, SPXEW had positive annual returns in 13 of the 16 years, while SPX had positive returns in 12 years. The average negative return was lower in SPXEW by 138 basis points. Finally, between the two indexes, SPXEW had the highest positive return in any given year (40.97% in 2003) and the lowest negative return (-18.18% in 2002). Slight advantage SPXEW.

There were 14 three-year rolling returns over this 16-year period. The average was 13.6% for SPXEW and 11.8% for SPX. The volatility of the 14 rolling returns was 7.9% for SPXEW and 13.0% for SPX. If performance is measured on the basis of average five-year rolling returns, SPXEW continued to dominate. The average of its 12 five-year rolling returns was 13.01%, compared to 11.63% for the market cap weighted SPX. Differences in the volatility of five year rolling returns highly favored SPXEW. Huge advantage SPXEW.

The final portion of the table displays returns over sequential 4-year periods: 1990-1993, 1994-1997, 1998-2001, and 2002-2005. SPXEW demonstrated significantly higher 4-year annualized return in 3 of the 4 periods, particularly during the most recent two periods.

Based on performance during the past 16 years, SPXEW clearly demonstrates that it is a more reliable measure of a broader U.S. equity market. Obviously it will under perform SPX when mega cap stocks are hot. The only downside of the SPXEW is a logistical issue; namely that there is currently only one ETF and one purchasable mutual fund that tracks it-Rydex S&P Equal Weight ETF and the Morgan Stanley Equal Weighted S&P 500.

Rydex's ETF has an annual expense ratio of 0.40% compared to 0.70% to 1.40% for the Morgan Stanley fund (based upon which share class is purchased). For comparison, the average expense ratio among the 156 index funds (multiple share classes included) that clone the SPX is 0.58%. If redundant share classes are removed, there are 67 unique SPX tracking index funds with an average expense ratio of 0.37%. However, if the expense ratio is weighted by net assets, the average expense was 0.17% as of 12/31/05. Consider that the five largest SPX clone funds possess 68% of all the assets and that their average expense ratio is 0.11%.

The SPX is the most cloned and benchmarked index on the planet, if not the known universe. What if the SPXEW were used instead? As shown in "Musical Benchmarks" the impact would be significant. The data in this figure were derived by comparing the performance of 84 actively managed U.S. equity funds that have the SPX as their best-fit index, at least 80% of their portfolios in U.S. stocks, and which had 10 years of performance history as of 12/31/05 (Morningstar Principia was the raw data source).

From 1996-1999 the SPX was a tough benchmark to beat whereas between 40%-80% of actively managed funds beat the SPXEW. This is hardly surprising. During this period the performance of mega cap firms (particularly technology firms) was stunning. For example, at year-end 1999, the average five-year annualized return for the largest U.S. 100 companies (based on outstanding shares) was 36.5% whereas the average 5-year return for all 4,122 U.S. companies was 10.3%.

During the six-year period from 2000-2005, no more than 30% of actively managed funds beat the SPXEW in any given year, whereas between 30% to 80% of actively managed funds beat the SPX. During this particular period, equity performance was distributed more evenly across market cap, with mega cap stocks generally underperforming mid and small caps. At year-end 2005, for instance, the average 5-year return for the largest 100 U.S. companies was -1.04% compared to 6.35% for the 5,288 companies in the Morningstar stock database.

Because of equal weighting, the SPXEW better reflects the performance of the broad U.S. equity market in spite of the fact that it holds the same 500 stocks as the SPX. This is verified by the fact that from 1990-2005 the correlation of the Equal Weighted Dow Jones Wilshire 5000 Index (EW 5000) with the SPXEW was 81%, whereas the correlation between the EW 5000 and SPX was only 59%.

For active large cap managers who construct and manage their portfolio in accordance with the market cap weighting protocols of the SPX, the SPX is a relevant benchmark index. However, actively managed large cap funds that do not attempt to mirror the market cap weighting of the S&P 500 Index (SPX) might more appropriately be "benchmarked" against the SPXEW. As shown in "All Over the Map", the same 84 actively managed U.S. equity large cap funds as described above demonstrate significant deviation from the Vanguard Index 500 Fund (shown by pink dot) in terms of portfolio market capitalization and the percentage of the fund allocated to large cap stocks. With nearly $70 billion in net assets as of 12/31/05, Vanguard 500 Index (VFINX) is the largest SPX clone fund.

In short, there is evidence that building market cap weighted portfolios is the not the mantra of all active large cap managers. For them, there's a new index in town.

More Return, Less Risk

16 Year Period	S&P 500 Equal Weighted Annual Returns   (SPXEW)	S&P 500 Market Cap Weighted Annual Returns   (SPX)
1990	-11.94	-3.10
1991	35.51	30.47
1992	15.63	7.62
1993	15.12	10.07
1994	0.95	1.32
1995	32.03	37.58
1996	19.02	22.96
1997	29.05	33.36
1998	12.19	28.58
1999	12.03	21.04
2000	9.64	-9.10
2001	-0.39	-11.89
2002	-18.18	-22.10
2003	40.97	28.69
2004	16.95	10.88
2005	8.06	4.91
Annualized Return
16 Year Average Annualized Return (%)	12.42	10.55
16 Year Standard Deviation of Return (%)	16.17	17.89
Growth of $10,000 over 16 years ($)	65,087	49,767
Performance Characteristics
Average Positive Return (%)	19.01	19.79
Number of Years with a Positive Return	13	12
Average Negative Return (%)	-10.17	-11.55
Highest Annual Return (%)	40.97	37.58
Lowest Annual Return (%)	-18.18	-22.10
Rolling Returns
Average of 14 Three-Year Rolling Returns (%)	13.60	11.80
Std Dev of 3-Year Rolling Returns (%)	7.90	13.00
Average of 12 Five-Year Rolling Return (%)	13.01	11.63
Std Dev of 5-Year Rolling Returns (%)	5.91	10.54
4-Year Block Returns
Annualized Return from 1990-1993 (%)	12.27	10.62
Annualized Return from 1994-1997 (%)	19.62	22.96
Annualized Return from 1998-2001 (%)	8.24	5.66
Annualized Return from 2002-2005 (%)	9.88	3.92

Musical Benchmarks

All Over the Map

84 large cap U.S. equity funds with SPX as the best-fit index. Three-year data as of 12/31/05. Pink dot represents VFINX.

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Craig L. Israelsen, Ph.D. is an associate professor at Brigham Young University. He teaches family finance in the Department of Home and Family Living. His research interests include mutual fund analysis. He writes monthly for Financial Planning magazine. Learn more about Craig Israelsen at http://familyliving.familylife.byu.edu/faculty/israelsen.htm