Study after study has proved plain-vanilla index funds such as the SPDR S&P 500 ETF (SPY) beat actively-managed mutual funds in the long run. There may be a way to beat the S&P 500 at its own game — equal-weighting its stocks holdings.

The market-cap weighted SPDR S&P 500 ETF (SPY) holds stocks based on the total market value of their shares. It’s like making a fruit salad with one of each fruit: one watermelon, one honeydew, one apple and one grape. The sheer size of the watermelon, or the biggest stock, dwarfs the smaller components. Whereas an equal-weighted fruit salad or index holds the same amount of each fruit. In turn, you get less exposure to the big stocks and more exposure to the small ones.

The latter method of slicing and dicing the market may be better for investors’ palates and wallets. The Guggenheim S&P 500 Equal Weighted ETF (RSP) returned 15.4% in the trailing 12 months, according to Morningstar, as of Jan 3. By contrast, the SPDR S&P 500 ETF (SPY) returned 12.9% over the same period.

The Invesco Equally-Weighted S&P 500 Fund (VADAX) is the only fund of its kind with a 15-year track record. It returned 8.7% annualized over the past 15 years, surpassing the SPDR S&P 500 ETF (SPY), which returned 6.7% on average over the equivalent period.

Historical Returns of Equal-Weighted ETFs and Mutual Funds Vs. SPDR S&P 500 ETF (SPY)
Name Ticker % Total Return 12 Month % Total Return 5 Year % Total Return 10 Year % Total Return 15 Year % Dividend Yield TTM Beta 3 Year mil$ Market Cap
Guggenheim S&P 500® Equal Weight ETF RSP 15.42 14.92 7.94 — 1.2 1.03 22,775.09
Index Funds S&P 500 Equal Weight No Load INDEX 15.38 — — — 1.13 — 21,673.46
Invesco Equally-Wtd S&P 500 A VADAX 15.1 14.71 7.8 8.69 1.03 1.03 22,384.90
iShares MSCI USA Equal Weighted EUSA 14.98 13.92 — — 1.59 1.05 19,010.35
PowerShares Russell 1000 Equal Wght ETF EQAL 16.51 — — — 1.57 — 11,207.23
SPDR® S&P 500 ETF SPY 12.86 14.39 6.97 6.55 2.03 1 79,652.24
Source: Morningstar as of Jan. 3, 2017

“Those who rely on capitalization-weighted index funds end up making big sector bets they didn’t necessarily want,” says Craig Birk, executive vice president of portfolio management at Personal Capital. The San Carlos, Calif.-based firm oversees $3.4 billion in assets.

 “For example, technology was about a third of the S&P 500 in 1999 before falling 80% in the dot-com crash,” Birk added. “Financials was almost a quarter of the index before it too fell 80% in the subprime crisis. These sector bubbles caused unnecessary damage to traditional index holders.”

Historical Weightings of the Technology and Financial Sectors in the S&P 500 (Source: Personal Capital)

Historical Weightings of the Technology and Financial Sectors in the S&P 500 (Source: Personal Capital)

Birk recommends having equal-weighted exposure to all sectors. Citing research conducted by Russell Investments in 2010, Birk says equal-weighted indexes offer bigger returns long term with less volatility compared to market-cap weighted indexes. This was seen in small-, mid- and large-cap U.S. indexes as well as foreign development markets and emerging markets.

“Those who try to guess the best sectors for next year are more likely to be wrong than right,” Birk says. “Take the recent election for example. The consensus was that if Donald Trump won the election, it would be a boon for health care stocks. But instead, health care is lagging the broader market.”

Historical returns of S&P 500 sectors using index ETFs as proxies. (Source: Personal Capital)

Historical returns of S&P 500 sectors using index ETFs as proxies. (Source: Personal Capital)

CFRA, a global independent equity research firm, has an overweight rating on the Guggenheim S&P 500 Equal Weighted ETF (RSP).

“With gains for the market-cap weighted S&P 500 being more limited in 2017, an equal-weighted approach that has reduced exposure to some of 2016 winners is a prudent approach,” Todd Rosenbluth, director of ETF research at CFRA, said in an email.

A Simpler and Better Way to Index

It appears the Index Group in Colorado Springs, Colo. followed the adage “if you can’t beat them, join them” in launching the Index Funds S&P 500 Equal Weight (INDEX) in April 2015. The mutual fund currently has $8.1 million in assets and charges a 0.3% annual expense ratio.

 “ The equal-weight version of the S&P 500 Index is the pure version of the index because it invests in each of the 500 companies equally, without bias,” lead portfolio manager Michael G. Willis wrote in a commentary. “By definition, this makes it a better-diversified version of the index as it does not overweight a select few. Incredibly, since its inception in 2003, this simple and logical version of the index has outperformed its ‘big brother’ nine out of 12 years.”

He added:  “This is in stark contrast to the market-cap, version which uses a complex formula that winds up allocating over 50% of the portfolio to only 50 companies.”

 Willis says he tried to beat S&P 500 for 20 years with stock picking. Now he says owning an equal-weighted version of the S&P 500 is much simpler and better. It allows investors to focus on their long-term goals and ignore the chatter on Wall Street.

“A key benefit of index investing is the peace of mind factor,” Willis wrote in a commentary. “ Since no one knows the future, why second guess it or attempt to time it? An index portfolio manager’s read on current market conditions doesn’t matter, as their job is to track the index and ignore everything else.”