The choices:
- Traditional Cap-Weighted S&P 500 - stocks are weighted according to their total market capitalization (stock price x number of shares); the oldest and largest ETF in this category is the US-traded SPDR S&P 500 (symbol: SPY)
- Fundamental Index - stocks are weighted according to a mix of four accounting measures of company size - sales, cash flow, book value and dividends; the ETF here is the Powershares FTSE RAFI U.S. 1000 Portfolio (PRF)
- Equal Weight Index - each stock in the S&P 500 receives the same weight of 0.20% (100% / 500); the one and only ETF that follows this method is the Rydex S&P Equal Weight ETF (RSP)
The table below shows some of the characteristics of each ETF and recent performance data, with green cells highlighting the ETF that does best for each element. Though each ETF has the same number of green cells, the really important figures to the investor are ultimately the total return (a combination of dividends and stock price increase) with consideration of the risk. These key factors at the bottom of the table, which come from Morningstar.com, are highlighted in bold text.
Fundamental Weight and Equal Weight Out-Perform Cap-Weight
The Google Finance chart of SPY, PRF and RSP market price since PRF was launched at the end of 2005 gives a visual confirmation of the comparison table numbers.
- on both 3-year and 5-year total return, PRF and RSP have done significantly better than SPY - between 1.3% and 1.8% per year better
- on a risk-adjusted basis, as measured by the Sharpe ratio, which divides returns by volatility of returns, PRF and RSP both do better than SPY
Of course, three years and even five years is a short time to judge investing success and the question is whether the better performance would be sustained in the long term through many economic cycles and conditions.
Some measure of support, though it can never be absolute proof, comes from academic studies. In March 2008, the EDHEC Risk Institute, a body associated with a university in France, published A Comparison of Fundamentally Weighted Indices: Overview and Performance Analysis. The study found that both Fundamental and Equal-Weight indices out-performed the S&P 500 by around 2% per year over the period from 1965 to 2006. The study also found higher Sharpe ratios for the Fundamental index. Finally, the study calculated the Sortino ratio, which considers only the downside return vs risk, and it too showed that the Fundamental index (they did not figure out the Sortino ratio for the Equal Weight index) did much better than the S&P 500. That the recent performance figures follow the same pattern of out-performance, during a subsequent time period of singularly traumatic market stress, is reassuring.
What's are the Risks?
If these alternate indices and associated funds have done so well, what could go wrong and what are the potential downsides?
- the future may not be like the past - though 45 years of data is starting to get long, it may still not be enough to ensure success
- the ETF lags the index - the research paper studied the performance of the ideal, the index; matching that in real investing must overcome the practical implementation issues and these are more of a drag on the fundamental and equal weight indices than the cap-weighted; the comparison table shows a much bigger negative tracking error for both PRF and RSP than SPY. Will that performance drag stay the same and allow lesser but still appreciable return advantage to continue?
- the equal-weight and fundamental strategies will likely under-perform by a lot for lengthy periods; the study again helps demonstrate the possible size of this risk - for over seven years from 1993 to 2001, the fundamental index fell behind the S&P 500, reaching a maximum 22% lag. The nature of the fundamental index means that it will do less well in comparison to the S&P 500 when there is a really strong bull market or bubble. The fundamental fund returns won't be negative, they will not be nearly as attractive. Will the investor be able to watch and hold tight for that long in the hope or expectation that later returns will rebound and more than make up for the lag?
There are no broad US market equal-weight funds available in Canada at the moment.
Fundamental weight - four funds are available based on the same RAFI 1000 index:
1) Claymore Canada offers two ETFs, one of which hedges US vs Canadian dollar currency shifts and the other does not.
- Claymore US Fundamental Index ETF (non-hedged) (CLU.C, MER 0.65%) and
- Claymore US Fundamental Index ETF C$ Hedged (CLU, MER 0.65%)
3) PRO FTSE RAFI US Index Fund (PRO901 for Class A DSC, MER 1.6%) - another mutual fund, started up in March 2007
Note that the currency factor, whether hedged or not (see previous post discussing this issue), and higher MERs will greatly affect net returns for the Canadian investor.
Alternative index schemes are an intriguing investment possibility that have attracted much discussion and criticism, as well as quite a bit of investment money (see net assets of RSP and PRF in the above comparison table). For the online DIY investor, as usual, whether to buy in is a decision you must make for yourself. Or, you can always seek professional guidance.
Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.
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