Improving on Index Funds

When it comes to making investing simple, it's hard to beat the index mutual fund. With a single investment, you automatically get exposure to hundreds or even thousands of different stocks, building a diversified portfolio with a single purchase. From specialized indexes that focus on particular sectors, to broad-based indexes that measure the entire market, you can usually find a mutual fund or ETF that tracks the index you want.

As useful as index funds are, however, they aren't perfect. Yet as the fund universe continues to evolve, new funds have emerged that try to improve on their first-generation counterparts. And one fund in particular has its sights set high -- on the pioneer of exchange-traded funds, the SPDR Trust.

If it ain't broke ...
You might think that trying to improve on S&P 500-tracking funds would be like trying to sell New Coke. After all, the SPDRs was the first exchange-traded fund, and its largest counterpart in the traditional mutual fund universe, the Vanguard 500 Index Fund (FUND: VFINX  ) , has been around in its current form since the 1970s.

But that's exactly what the Rydex S&P Equal Weight ETF (AMEX: RSP  ) seeks to do. Since its 2003 inception, the fund has tried to exploit the S&P 500's method for weighting its component stocks.

Are all stocks created equal?
Specifically, the Rydex fund notes that traditional index funds don't provide as much diversification as they seem to. Although many S&P 500 funds do hold roughly 500 stocks, the index puts a huge emphasis on the largest companies in the index. Nearly 20% of the entire value of SPDRs lies in the index's 10 largest stocks. Meanwhile, the bottom 50 stocks make up less than 1% of the SPDRs portfolio. With that little impact, those smaller stocks don't provide much additional diversification.

On the other hand, the Rydex fund tries to own equal weights of all of its component shares. In practice, the fund doesn't do a perfect job of keeping things exactly equal, but its top 10 holdings add up to less than 3% of its portfolio. And at the other end of the spectrum, the bottom stocks still have a measurable impact on the fund's return.

Stock	Weight in SPDR	Weight in Rydex ETF
ExxonMobil (NYSE: XOM  )	3.91%	0.21%
General Electric (NYSE: GE  )	2.93%	0.19%
Microsoft (Nasdaq: MSFT  )	2.20%	0.26%
Apple	1.28%	0.28%
Google (Nasdaq: GOOG  )	1.23%	0.26%
Sears Holdings (Nasdaq: SHLD  )	0.06%	0.17%
Jabil Circuit (NYSE: JBL  )	0.03%	0.15%

Clearly, Rydex hopes that the smaller stocks in the index will outperform their larger brethren. If they do, the Rydex fund should outperform traditional S&P 500 index funds. On the other hand, when the big names do well, the Rydex fund will lag behind those other funds.

The jury is still out on whether an equal-weight fund will have better long-term performance than traditional market-cap-weighted funds. The fund started out strong, substantially outperforming the S&P. But over the past couple of years, the fund has fallen behind the benchmark, giving up those earlier gains. After just four years, the fund trails the S&P by about 0.2%, which is about half of its 0.4% expense ratio.

Given the success of index funds and ETFs, you can expect to see plenty of attempts from fund companies to build a better index. But for most investors, the funds available now should continue to work well.

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