How to Build a Better S&P 500

As terrific as S&P 500 index funds can be, they're not perfect. But a newer, potentially better kind of index fund could help fix one of their biggest weaknesses.

S&P 500 index funds tend to charge very low fees while delivering close to the market's overall return. They also provide instant diversification into 500 companies. With such index funds, you don't have to spend much time scouring the market for the most compelling stocks, or figuring out when to buy (or sell) them.

Unfortunately, the S&P 500 is capitalization-weighted -- the bigger the component, the greater its influence. Therefore, its top holdings are ExxonMobil, Microsoft, and Procter & Gamble -- with ExxonMobil alone accounting for more than 3% of the index. The top 30 holdings make up some 40% of the index, leaving the remaining 470 companies to make up the other 60%. The smallest holdings each make up about 0.01% of the index, which means any change in their performance has almost no effect on the index as a whole.

Equality for all
Equally weighting the index could help address those inequities. The Rydex S&P Equal Weight (RSP) ETF holds the same 500 stocks as a typical S&P 500 fund, but there's no 3% vs. 0.01% discrepancy among its holdings. Each of the companies it holds represents 0.02% of the index. Despite having a fraction of the market cap of top S&P 500 stocks, Valero Energy (NYSE: VLO  ) and Harley-Davidson (NYSE: HOG  ) get equal representation in the ETF.

As you might imagine, constructing an index this way means the sector weightings end up quite differently:

Sector

Equal-Weighted

Market-Cap-Weighted

Software

3.81%

4.43%

Hardware

7.57%

10.82%

Consumer Goods

12.11%

11.07%

Financial Services

16.35%

16.12%

Utilities

6.17%

3.38%

Health Care

9.06%

11.65%

Telecommunications

3.50%

5.24%

Data: Morningstar. All figures as of March 9. Market-cap weighted figures are for iShares S&P 500 ETF (IVV).

Look how much utilities jump, even as hardware stocks fall quite a bit. That's because even the biggest utilities, such as Exelon (NYSE: EXC  ) and Duke Energy (NYSE: DUK  ) , aren't all that big, while huge companies such as Apple (Nasdaq: AAPL  ) , Cisco (Nasdaq: CSCO  ) , and IBM (NYSE: IBM  ) dominate the hardware space.

An equal-weighted S&P 500 index fund is worth considering if you want to benefit from the overall performance of all the S&P 500 companies. Bear in mind, however, that at 0.40%, the Rydex fund does cost a little more than some index ETFs. Also, since it was only launched in 2003, it doesn't have the longest track record for drawing meaningful comparisons.

Still, the fund could give you a chance to benefit from more than just a relative handful of overweighted ultra-large-cap companies. More importantly, it never hurts to have a wider spectrum of choices when you're shopping for an index fund.

Equal-weighted or capitalization-weighted: What's your favorite option? Sound off in the comment box below.

Longtime Fool contributor Selena Maranjian owns shares of Apple, Procter & Gamble, and Microsoft. Exelon and Microsoft are Motley Fool Inside Value recommendations. Apple is a Motley Fool Stock Advisor selection. Duke Energy and Procter & Gamble are Motley Fool Income Investor choices. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of Procter & Gamble. Try any of our investing newsletter services free for 30 days. The Motley Fool is Fools writing for Fools.


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