The good ol' S&P 500 Index fund is the cornerstone of Foolish investing for very simple reasons. It has low fees, is easily available, and regularly outperforms 80% or more of managed mutual funds. It's a tough combination to beat, and it requires next to no effort if you're regularly contributing to a 401(k) fund.
But what if you could take the S&P 500 and improve upon it without drastically changing all the things that have made this index fund so great? All the better to my mind, which is why the recent findings in a research paper I stumbled upon, and portions of the new book from Jeremy J. Siegel, have my brain buzzing.
Think Main Street, not Wall Street
When Wall Street thinks about measuring a company's size, it thinks market cap or maybe enterprise value. (OK, I think this, too.) But when Joe on Main Street thinks of a company's size, he probably thinks of revenues, profits, or maybe even the number of employees at the company. Thinking the way Wall Street thinks, it offers weighted index funds that you and I purchase, such as the Vanguard 500 Index (FUND:VFINX), by market cap. In the paper "Redefining Indexation" by Robert Arnott, Jason Hsu, and Phil Moore at Research Affiliates, the reason for the prevalence of market-cap weighting is attributed to the capital asset pricing model, or CAPM. However, for reasons of simplicity, we won't get into the CAPM model and the theory behind it today.
The drawback to using market-cap weighting is that companies that are often dearly valued, like Yahoo! (NASDAQ:YHOO) or Starbucks (NASDAQ:SBUX), are more heavily weighted in the index, because their high prices cause them to have larger market caps. On the flipside, companies like Motley Fool Income Investor pick Heinz (NYSE:HNZ) or Golden West Financial (NYSE:GDW), which rarely sell at rich premiums, are underweighted in the index, and in turn, the index misses out on their potential outperformance.
To look at things in a different light and without the effects of Mr. Market on equity prices and market caps, Arnott, Hsu, and Moore took the Main Street approach to measuring company size and built alternative index model funds using data from 1962 to 2003 to see how they would have performed against the market-cap-weighted S&P 500 Index. To do this, they took the 1,000 largest companies by book value, income, revenue, sales, gross dividends, and number of employees and created an alternative model fund for each measurement of size. They then weighted the companies by that size measurement and re-weighted each alternative fund once a year.
The results are interesting because each of the model funds outperformed the S&P 500 index by approximately 2% per year. Not only that, but each of the alternative model funds outperformed in bull and bear periods, and in periods of rising or falling interest rates. The findings of Arnott, Hsu, and Moore are without a doubt worthy of investor attention and validation. Here's hoping that we see index weighted by something other than market cap in the near future.
Just leave it alone!
You can't invest in the original S&P 500 from 1957, but you may be interested in what Professor Jeremy J. Siegel reveals in his new book, The Future for Investors. It took a large amount of manual effort, but in his book Siegel reveals that the original S&P 500, with dividends reinvested, and with all of its spinoffs and acquirers held until 2003, would have outperformed the rebalanced and updated S&P 500 that's available to all of us now by 0.55% per year. That may not sound like much, but over 46 years, that's a nest egg that's about 21% larger.
It's important to note that Siegel isn't proposing the index fund with no changes as a potential alternative to investors. What the comparison is meant to show is that what's new is often overvalued, whereas what's tried and true tends to be undervalued and, despite its slower growth, earns investors larger returns because of a more favorable valuation and reinvested dividends.
Foolish final words
If there is a positive about periods of flat or declining performance -- such as the past five to seven years -- in the investment world, it's that people start asking questions about the status quo and we start looking at our investments differently.
Does this mean the market-cap-weighted index fund is all washed up? No, not at all. Despite the flat performance of the S&P 500 index over the past five years, an S&P 500 index fund is still one of the best options out there for investors to build their portfolio around, if they're investing for the long-term. And until there is a competing option available for purchase in the market with a cost structure and track record that matches the performances of the S&P 500 index fund, there is no reason to think differently. But do keep your eyes peeled for that revenue-weighted index fund. I know I will be.
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Nathan Parmelee owns shares of Starbucks but has no financial interest in any of the other companies mentioned. You can view his profile here . The Motley Fool has an ironclad disclosure policy .
