For many, it may seem that similar exchange-traded index funds are actually identical. And when you think like that, you may defer to the biggest and baddest ETF on the investment block.
For example, most investors recognize the long-standing granddaddy of them all, the S&P 500’s preeminent proxy, the S&P 500 SPDR (SPY). The original S&P 500 that can be seen on CNBC is a traditional market-cap weighted index. What this means is… the bigger the company in the S&P 500, the more weight or power it has to move the benchmark up or down.
Critics of market-cap weighting typically describe the effect as misleading. In 1999, for instance, when you thought that the Nasdaq 100’s QQQQs were fairly representing the largest 100 stocks on the Nasdaq exchange, what you were really getting was 50% Microsoft, Intel and Dell. Three stocks had the power to move the Nasdaq 100 at the height of the tech boom.
It follows that a number of companies have presented alternatives to the traditional model. One such alternative is the creation of equal-weighted indexes. The Rydex S&P 500 Equal Weight (RSP) does what its name implies; that is, it gives every company in the S&P 500 the same weight or power. (In mathematical terms, that represents 0.20% weighting for each of the 500 companies.)
The reason is actually quite simple. The highest weighting in the S&P 500 today is the financial sector. Yet the last 2 years have seen financials struggle with rising interest rates and, more recently, sub-prime lending woes. In contrast, the best performing subsegments of the economy in the last 2 years have been the companies with significantly lower weightings overall: materials, utilities and energy. When all companies have an equal weight, however, the companies in these sectors have a bigger influence on the index investment.
Market cap indexes work best in times when you want the momentum of the most powerful companies to help drive your investment higher. In the late 90’s, technology had a 33% weighting in the S&P 500, and that helped propel the index to new highs. But that overweighting also helped to sink the S&P 500 during the tech-induced bear market from 2000-2002, such that the S&P 500 lost 1/2 of its value!
Rather than buy-n-hold one ETF over another, it simply becomes more relevant to understand when a market-cap weighted index (e.g., S&P 500 SPDR) or an equal weighted index (e.g., Rydex S&P 500 Equal Weight) is in the driver’s seat. Or for that matter, when an earnings-weighted index or dividend-weighted index might take charge. But that’s for another weblog post!
Disclosure Statement: As a Registered Investment Advisor, Pacific Park Financial, Inc. may hold positions in the ETFs, mutual funds and/or index funds mentioned above.