Index investing has grown increasingly popular in recent years, as more and more retail investors learn about the simplicity and low fees associated with the strategy.
Warren Buffett has long told investors that putting their money in a low-fee S&P 500 (^GSPC +1.05%) index fund is one of the smartest things they could do with their money. He even recommends it over Berkshire Hathaway, his own company's stock. The Oracle of Omaha has even instructed the executor of his estate to put almost all his assets in an S&P 500 index fund for his wife.
The components of the benchmark index are all widely traded with lots of liquidity, which means most index fund companies can offer very competitive products. Currently, investors can pay expense ratios as low as 0.03% for multiple S&P 500 index funds. But if you have $1,000 to invest, it might be worth paying a little more for an S&P 500 index fund that does things just a little bit differently.
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Why do things differently?
Instead of going with a traditional cap-weighted S&P 500 index fund like the Vanguard S&P 500 ETF or the long-standing SPDR S&P 500 ETF, investors with $1,000 to invest right now might want to consider an ETF tracking the S&P 500 equal-weight index.
The S&P 500 equal-weight index takes all 500 components of the S&P 500 and, as the name suggests, tracks the change in price of an index where they each hold equal weight at the start of the quarter. The weights are rebalanced each quarter when the S&P 500 reconstitutes.
The appeal of the equal-weight index is that you get additional exposure to the smaller companies in the index, which theoretically have more room to grow. The S&P 500 is currently dominated by just a handful of companies. The top 10 companies by market cap make up over 37% of the entire index's value. By contrast, those 10 companies account for just 2% of the equal-weighted index, the same amount as the smallest 10 companies in the index.
But portfolio concentration isn't the only concern right now. Those big companies at the top of the index also command very high valuations. Some may argue they deserve premium pricing, as these are the companies leading the artificial intelligence (AI) revolution and capitalizing on the massive amounts of investment into AI.
But their high prices have pushed the S&P 500's overall forward P/E to more than 22. That's well above the historic average for the index in the mid-teens, and at levels we've rarely seen since right before the dot-com bubble.
If you weight all the components of the S&P 500 equally, the overall forward P/E is just 17.6, which is much more reasonable.
The equal-weight index has outperformed the cap-weighted index over the long run due to those factors. However, that hasn't been true over the last decade, with an even bigger discrepancy over the last three years. But the market typically exhibits reversion to the mean, and given where we stand today, the equal-weight index looks poised to outperform again over the long run.
The best S&P 500 ETF to buy with $1,000
While there are a lot of cap-weighted S&P 500 ETFs available for purchase, there aren't very many equal-weight index funds. The best option for U.S. investors is the Invesco S&P 500 Equal Weight ETF (RSP 0.04%).
The Invesco fund charges an expense ratio of 0.2%, well above the 0.03% of cap-weighted index funds like Vanguard's. But the added expense can be worth it if we see the expected mean reversion to smaller, lower-priced stocks.
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Key Data Points
It's also worth pointing out that the Invesco fund managers haven't produced any capital gains distributions for shareholders since its inception. So, you don't have to worry about any additional tax drag from an index fund that rebalances every quarter.
If you decide to invest your $1,000 in the Invesco S&P 500 Equal Weight ETF, you are taking a risk of underperformance. There's a chance the next 10 years look similar to the last decade, where big companies got bigger faster than the smaller companies. If you want to guarantee returns that look like the S&P 500, your only option is to go with something like the Vanguard S&P 500 ETF. But right now looks like a great opportunity to overweight your portfolio to the smaller companies in the index and potentially outperform.
