Greg Brown - Writing Clip - Consumer Reports Money Adviser - Index Fund Investing Feature

quent purchases of futures contracts to reach their objectives, and that increases their operating costs.

What’s more, over time, leveraged and short index funds will dri! from the “indexes” they track. Plain-vanilla index funds deviate only slightly from the benchmark except on rare oc-casions, while the deviation among leveraged and short index funds is greater.

EQUAL-WEIGHT FUNDSBut not all index-fund game changers are necessarily costly

or deviant. In the past "ve years, a variant of index funds has gained attention and assets: equal-weight funds. #ese do ex-actly what their name suggests—they invest equally in each company in the index. To understand the signi"cance of this,

Index funds, those passive portfolios designed to track the performance of market indexes, now dominate the mutual-fund landscape. Even during the dreadful past de-

cade for stocks, index funds still received positive in$ows every calendar year. Contrast that with managed funds, whose assets have fallen by tens of billions over the same period. In June, when U.S. stocks took a modest beating, $19 billion $owed out of managed funds, while index funds took in $1 billion of new money, according to Morningstar.

Part of the explanation might lie in the subpar performance of stocks over the past decade. Investors might realize they still need to be in stocks, but when the annual return over 10 years is less than 3 percent, they don’t want to fork over a third of that gain to an active fund manager.

Over the years, running an index fund has become much cheaper thanks to lower transaction costs and new technol-ogy. #e lowest-cost index funds charge you only $10 for every $10,000 invested each year, an expense ratio of 0.10 percent. But it takes a lot of assets to run an index fund e%ciently. Index funds managed by fund families smaller than Vanguard and Fidelity will probably charge you a little more, but still well under 0.5 percent.

As you can see by the table at right, the lowest-cost S&P 500 funds tended to perform better over 10 years than those with higher expense ratios. Over the long haul, low expenses trans-late into more for you. A $100,000 investment in the lowest-cost index fund earning 7 percent a year over 10 years becomes $194,700, while that same investment and return at the average managed fund results in only $180,800.

NEW INDEX-FUND VARIATIONSUnfortunately, even the lowest-cost index funds have fallen

far short of the historical average for stocks over the past de-cade. Is there a way to tweak an index fund to get a larger gain?

Well, yes, but generally you’ll need to assume a greater risk to get a better return on your investment. Of course, the mutual-fund industry is more than eager to supply you with a menu of index-fund enhancements to do just that. Some of the newer exotica include leveraged index funds (where the fund attempts to multiply the return of the index) and short index funds (which bank on stocks falling in price). While these types of funds might have a tactical role for traders, they’re of little use to the long-term investor. #ey rely much more heavily on fre-

New twists on index fundsDo equal-weight funds have a place in your portfolio?

Fund costs affect returnsWe ranked the largest S&P 500 index funds by 10-year to-tal return. In general, the less expensive the fund, the more the investor kept.

Fund (ticker) Expense ratio

10-year total return

(annualized)

DFA US Large Company (DFUSX) 0.10% 2.72%

Schwab S&P 500 (SWPPX) 0.09 2.66

Vanguard 500 (VFINX) 0.17 2.62

Fidelity Spartan 500 (FUSEX) 0.10 2.61

SSgA S&P 500 (SVSPX) 0.18 2.56

Dreyfus Basic S&P 500 (DSPIX) 0.20 2.55

Columbia Large Cap (NINDX) 0.17 2.54

USAA S&P 500 (USSPX) 0.25 2.49

T. Rowe Price Equity Index 500 (PREIX) 0.30 2.47

VALIC Company I Stock (VSTIX) 0.38 2.38

Northern Stock (NOSIX) 0.25 2.36

Dreyfus S&P 500 (PEOPX) 0.50 2.25

BlackRock S&P 500 (MDSRX) 0.56 2.16Data: Morningstar. Returns as of June 30, 2011.

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let’s look at how indexes are created. Most indexes today are capitalization-weighted. !e Standard & Poor’s 500 index, for example, equals the sum of the values of the 500 companies within the index. !e largest component, recently ExxonMobil, accounts for 3.3 percent of the index, which is 16 times that of the average-sized S&P company. Apple is nearly as large as Exxon, and at times in recent weeks, has surpassed the oil giant. In total, the 10 largest corporations comprise 20 percent of the entire index

Because of this the cap-weighted S&P is heavily tilted to-ward mega-caps like Apple and Google, so your investment is concentrated in the biggest names. !is can be an advantage during economic downturns, since mega-cap stocks tend to have smaller losses than small-, mid-, and the merely large-cap companies. But during expansions, mega-caps usually under-perform, especially during the "rst months of a recovery. And this underperformance tends to continue throughout the cycle, which can o#en last a number of years.

REBALANCING ACTWith an equal-weight S&P 500 index fund, roughly 0.2 per-

cent of your investment is in Apple, Exxon, and each of the other 498 stocks of the index. Why roughly? Since some shares will gain or lose value relative to others over time, equal weight funds need to be periodically rebalanced. Currently, most equal-weight funds rebalance quarterly.

Rebalancing within an asset class, just as you do when you rebalance among the percentage of stocks, bonds, and other investments in your portfolio, can be bene"cial. !e fund can reduce shares that may have overheated and add some that may be a bargain. !is activity will increase the fund’s operating ex-pense. But annual turnover is still only about 20 percent a year, much lower than an actively managed fund.

Is the added expense worth it? Looking at the historical data, it could very well boost returns. Since the end of 2004, the equal-weight S&P 500 index has returned 7.4 percent a year, while the cap-weighted index returned only 5.2 percent. !e Rydex S&P Equal Weight ETF (ticker: RSP), with an expense ratio of 0.40 percent annually, is comparable in price to cap-weighted index funds, a thus a cost-e$ective way to invest in the S&P 500 on an equal-weight basis.

GREATER LOSSES DURING DOWNTURNSRydex also launched equal-weight ETFs for the S&P mid- and

small-cap indexes this past summer. But in those indexes, the capitalization weightings were already far less unequal. !e 10 largest mid-cap corporations account for only 7 percent of the S&P MidCap 400, for example, and the 10 largest small-caps ac-count for only 6 percent of the S&P Small Cap 600. Rebalancing there would have less of an impact on returns, so it’s less clear

if the extra costs of rebalancing these indexes would confer as much bene"t.

On the other hand, equal weighting also appears to am-plify losses during market pullbacks (see chart at right above). In 2008, when no equity investor was spared pain, the equal-weight index lost 40 percent, even worse than the 37 percent of the cap-weighted S&P index. But the equal-weight index proved to have much more snapback when the market came back the following year, recovering 65 percent of 2008’s loss vs. the 26 percent of the top-heavy S&P.

But keep in mind the argument that equal-weight indexes might underperform in the years ahead if large-cap stocks ever get their mojo back, as some market strategists suggest. !e arguments tend to run along a similar line: Large-cap stocks should be trading at a similar price-earnings multiple to smaller fry, since larger companies are a more secure investment. But since 2000 that, perversely, hasn’t been the case, as small-cap stocks have outperformed large-caps and now trade at a signi"-cantly higher price-earnings ratio.

In a sense, you can "ne-tune the equity portion of your port-folio by choosing an equal-weight index fund instead of the tra-ditional cap-weighted model. But remember that you’ll assume slightly more risk with the equal-weighted fund, and during a downturn the sting will probably be a bit sharper than the tradi-tional cap-weighted model. So long as expenses are low, either choice will make a "ne equity foundation for a portfolio. $

A weighty matterSince 2004, the equal-weighted S&P 500 has steadily outper-formed the traditional capitalization-weighted S&P 500 to the tune of 3 percentage points a year.

Data: Morningstar

-20

-10

0

10

20

30

40

50

60

70%

2004 2005 2006 2007 2008 2009 2010 2011

S&P 500 equal-weighted

S&P 500 cap-weighted

OCTOBER 2011 MONEY ADVISER CONSUMER REPORTS 9

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