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How to Choose Between Weighted Funds

Index funds look like a one-size-fits-all investing option, but in fact there are many alternatives to the S&P 500 products that dominate the market. Some choices are subsets of that broad market index and others track different indexes altogether including foreign or small-company stocks or certain industries.

Then there are the equally weighted index funds, which give the same billing to every stock in the fund, large or small, instead of plowing most of their money into big-company stocks. Advocates say equal weighting can sometimes provide bigger returns than the standard capitalization-weighted funds that emphasize big stocks.

“Equally weighted funds offer investors an opportunity to tilt their portfolio toward smaller companies rather than the few large companies that dominate most (cap-weighted) indexes, says Joshua Escalante Troesh, founder of Purposeful Strategic Partners in California.

[See: 7 Big Data Winners And Losers.]

“Considering that over a third of the money in an S&P 500 cap-weighted index is invested in the largest 25 companies, equally-weighted funds will also provide a little more diversification,” he says.

Some equally weighted funds have consistently beaten their cap-weighted equivalents. The Invesco S&P Equal Weight ETF (ticker: RSP) has returned an average of 14.62 percent a year over the past decade, beating the 13.26 percent of the S&P 500 SPDR index fund ( SPY), the big player among S&P 500 exchange-traded funds, according to Morningstar.

Funds tracking major indexes like the S&P 500 are the big players in the indexing world. That index is composed of the 500 largest U.S. stocks, measured by capitalization, or the share price times the number of shares in circulation.

Apple ( AAPL), with a market capitalization of $1.074 trillion, accounts for 4.377 percent of the index. It is followed by big-name firms like Microsoft Corp. ( MSFT) at 3.57 percent, Amazon.com ( AMZN), 2.85 percent, and Berkshire Hathaway ( BRK.A, BRK.B), 1.74 percent.

At the bottom of the list are News Corp. ( NWS) at 0.006 percent, Under Armour Class C ( UA), 0.016 percent, Newfield Exploration Co. ( NFX), 0.017 percent and Under Armour Class A ( UAA), 0.018 percent.

Obviously, this means that a big price change for Apple will have much more effect on the index than an equal change, by percentage, in one of the smaller stocks. An investment in this index is primarily a bet on stocks of the country’s largest companies.

Investors who want to bet on small-company stocks can choose a different index such as the S&P 600 or Russell 2000.

But another approach is an equally weighted fund that will put the same amount of money into little guys like News Corp. as in the big players. They track the S&P 500 equal weight index, with each of the 500 stocks taking up 0.2 percent of the index.

“The logic behind an equally weighted index fund is that no single holding has an oversized weight — positive or negative — on the performance of the index,” says Robert R. Johnson, finance professor at Creighton University in Omaha.

[See: 7 Founder-CEOs Doing Fabulously for Shareholders.]

He says an equally weighted fund can be an option today for investors worried about overpricing in the so-called FAANG stocks — the big tech firms Facebook ( FB), Apple, Amazon, Netflix ( NFLX) and Google ( GOOG and GOOGL)

“This may be an option that allows investors to protect themselves from adverse movements in some of the biggest names,” Johnson says.

FAANG stocks currently make up 8.06 percent of the cap-weighted S&P 500, but just 1 percent of the equally weighted version.

“Essentially, an equal weighted index is more diversified than a market cap-weighted index because no security has any greater influence than any other,” Johnson says.

“Smaller companies have historically performed better than larger companies, so an equally-weighted fund theoretically could perform better than a cap-weighted fund in the same index,” Troesh says.

Of course, performance over a given period will not necessarily persist in the future. An equally weighted fund might well beat its cap-weighted cousin when small stocks have a good run, but it would fall short if they falter.

Another issue is cost and tax efficiency, says Robert Stromberg, president, Mountain River Financial in Glastonbury, Connecticut. To maintain an equal weighting as prices change and investor money flows in and out, the equally weighted fund must constantly buy and sell shares. That creates trading costs and taxes on year-end distributions of net profits.

RSP charges 0.20 percent, compared to SPY’s 0.09 percent, Johnson says, adding the higher expenses are more than offset by RSP’s fatter returns.

“With cap weighting, the rebalancing essentially occurs naturally, thus reducing the need for buying and selling frequently,” Stromberg says. “Depending on the frequency of rebalancing back to equal weights, this cost and tax issue can be enormous.”

[See: 10 Reasons Investors Shouldn’t Panic About Stocks.]

That won’t matter, though, if the fund is held in a tax-favored account like an individual retirement account or 401(k).

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How to Choose Between Weighted Funds originally appeared on usnews.com



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