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Every investor wants to beat the market. But for many, that's easier said than done. So when a group of experts recently came out with three strategies that posted much better returns than the S&P 500 over the past decade, they drew plenty of attention. But the big question remains: Even if they worked in the past, will they keep working in the future?
Building a better index
Millions of investors follow major market measures like the S&P 500. But many of those investors don't understand exactly how those measures really work. If they did, some argue, they'd be less comfortable about investing their money using the methodologies that the big benchmarks use.
In particular, the S&P 500 is one of the most popularly followed market indexes. Standard and Poor's, which runs the index, says that about $4.8 trillion is benchmarked to the index. At roughly $95 billion, the SPDR S&P 500 weighs in as the biggest ETF, outpacing its nearest rival, the SPDR Gold Trust, by nearly $40 billion. So when it comes to following the crowd, you'd have trouble finding a bigger crowd to follow than those using the S&P 500 to chart their investing path.
But lately, following the crowd has led to some disappointing results. The S&P 500 weights its member stocks in proportion to their market capitalization, and from 1999 to 2010, that strategy resulted in returns of less than 1% annually for the index. But three alternatives -- equal-weighting, fundamental weighting, and a somewhat more complicated strategy that tries to manage risk efficiently -- have all produced returns of at least 5% per year over the period.
What's behind the difference?
To figure out whether those improved returns are likely to continue into the future, you first need to look at why they happened in the past. For the equal weighting strategy, which as its name suggests simply owns the same amount of all 500 stocks. So when small market-cap stocks do relatively better than the megacap stocks that dominate the S&P 500, an investment that follows the equal-weight strategy, such as Rydex Equal Weight (NYSE: RSP ) , will outperform.
That's been the case in recent years, with big-cap stocks struggling. Even just this year, some of the smaller stocks in the S&P 500 like JDS Uniphase (Nasdaq: JDSU ) , NVIDIA (Nasdaq: NVDA ) , and Big Lots (NYSE: BIG ) have put in some stellar performances. The reasons differ -- JDS Uniphase has benefited from the success of the Kinect gaming system, while NVIDIA's Tegra chips have become popular in new tablets, and Big Lots is simply part of the red-hot discount retail sector. But regardless of the reason, small caps have simply posted better returns, and that helps equal-weighted strategies.
On fundamental weighting, you can find a number of different ETFs that use various fundamental measures to build indexes. PowerShares FTSE RAFI U.S. 1000 (NYSE: PRF ) combines sales, earnings, and dividends to create its weighting scheme; its top holdings look very similar to that of the regular S&P 500 with one very notable exception: Perhaps because it pays no dividends, Apple (Nasdaq: AAPL ) doesn't appear until the 24th spot on the list, compared to its top-2 position in the cap-weighted S&P 500. Other ETFs pick specific metrics, such as WisdomTree Large-Cap Dividend (NYSE: DLN ) , which focuses on dividends.
The efficient-risk strategy doesn't have an ETF tracking it yet. But given the high interest in ETFs these days, it's only a matter of time before you'll have an investing option for that strategy as well.
Follow the cycle
When you look at the relative performance of these alternative ETFs compared to the S&P 500, one thing stands out: The strategies move in and out of favor. Some years, the S&P 500 wins; others, the alternatives win. Even a relatively long history of 10 years isn't enough to be certain that the alternatives are destined to outperform all the time.
Perhaps the most important lesson from this research is that the S&P 500 by itself doesn't give you all the diversification you need for a successful portfolio. Just as alternative strategies can enhance returns, so too can adding stocks outside the S&P 500. By making sure you have exposure to the whole universe of available stocks, you'll put yourself in the best position to reap the benefits regardless of which particular part of the investing world happens to be making the most money at any given time.
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