Market-Beating Returns Made Simple

You can easily match the market's return by buying an old-fashioned index mutual fund. To outperform the major market indexes, though, you may think you need to use sophisticated strategies, take on risky amounts of leverage, or become an ace at picking top stocks.

As it turns out, though, a strategy that's arguably even simpler than the one your plain-vanilla index fund uses has put together a long-term track record that has done a lot better than those S&P 500 index funds over time.

Are all stocks equal?
One common complaint about the typical S&P 500 index fund is that the index is weighted by market capitalization. As a result, the S&P 500's top 10 stocks account for fully 20% of the entire index -- a greater influence than the bottom 330 stocks have. Moreover, the biggest stock in the index, ExxonMobil (NYSE:XOM), has more than 400 times as much weight as some of the smallest stocks, such as Titanium Metals (NYSE:TIE).

The solution that some investors chose was to build a fund that bought equal shares of each of the index components. Using this equal-weight philosophy, an S&P fund would essentially have equal amounts invested in each of the 500 different stocks in the index.

Taking a look at the performance of some funds that have used this philosophy, you can see the results for yourself:

Source: Morningstar.

Equal-weight funds have done quite well compared to traditional index funds over periods of several years. The key to their outperformance is tied to how small-cap stocks have done relative to the large-cap companies that dominate the market-cap-weighted index funds.

Small-cap strength
Put simply, when you follow an equal-weight strategy, you'll end up owning more of the small- and mid-cap stocks that appear at the bottom of a market-cap-weighted list of component stocks, while holding smaller stakes in megacap stocks. As a result, if those smaller stocks do well, then equal-weight index fund shareholders will beat out investors in traditional index funds.

For much of the past 10 years, smaller stocks have indeed done better. Take a look at these top performers in the S&P since 1999:

Sources: Capital IQ (a division of Standard and Poor's); Yahoo! Finance.

More broadly, the majority of the top 50 performing stocks in the S&P 500 over the past decade have market caps of $10 billion or less. That's certainly consistent with the general trend of outperformance that small-cap stocks have over their larger rivals.

When it doesn't work
Of course, regardless of long-term trends, small companies don't always do better than big ones. In 2007 and 2008, for instance, smaller stocks did relatively poorly, and that performance was reflected in how equal-weight mutual funds did compared to regular index funds.

Yet so far in 2009, equal-weight funds are back to their winning ways. Because many analysts believe that small-cap stocks may well lead the economy out of the current recession, it's reasonable to expect equal-weight funds to continue their latest streak of strong performance as well.

Give small stocks a chance
So if you're looking for a simple way to improve on a useful tool, an equal-weight mutual fund might be worth a closer look. Even better, another alternative might be just to add some smaller stocks to your core portfolio of index funds -- ensuring that you'll have the small-cap exposure you need to beat the S&P 500 over the long haul.

For more on finding the right funds:

• These funds could make you a millionaire.
• You should jump on this opportunity before it disappears.
• Don't blow this great chance to invest.