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SPXEW has the same 500 constituents as the market cap-weighted SPX, but each company is allocated a fixed weight of 0.20%. Compared with SPX, SPXEW offers greater exposure to firms with smaller market capitalization, less exposure to mega-cap stocks, higher turnover due to quarterly rebalancing, different sector exposure and different risk/return characteristics. This study compares the performance of the SPXEW with SPX over the past 16 years. (SPXEW performance data is available back to January, 1990, on the Standard & Poor's website.)
PULLING OUT AHEAD
The table "More Return, Less Risk," below, compares the annual returns of the two indexes. The most striking initial observation is the cyclical pattern shown by which index is performing better (alternating color shading in the table). In the early 1990s, the SPXEW generated higher returns, whereas during the bull run of 1994 to 1999, the SPX outperformed the SPXEW by nearly 650 basis points. Undoubtedly this was because mega-cap stocks were generally the best performers during this period, and the SPX is much more sensitive to large-company returns. But during the dicier years, from 2000 to 2005, the SPXEW had a six-year annualized return of 8.06% compared with -1.13% for the SPX. When the largest companies in the index falter, so does the SPX.
Over the 16-year period from 1990 to 2005, the SPXEW's annualized return of 12.42% was 187 basis points higher than that of the SPX. Moreover, the SPXEW's volatility as measured by standard deviation was 172 basis points lower than the SPX. Advantage SPXEW.
Probing deeper, we observe that the SPX had slightly higher average positive returns than the SPXEW (19.79% versus 19.01%). However, the SPXEW had positive annual returns in 13 of the 16 years, compared with 12 for the SPX. And the SPXEW's average negative return was 138 basis points less negative than that for the SPX. Slight advantage SPXEW.
There were 14 three-year rolling returns over this 16-year period. The average annualized return was 13.6% for SPXEW versus 11.8% for SPX. The volatility of these 14 rolling returns was 7.9% for SPXEW and a significantly higher 13.0% for SPX. SPXEW continued to dominate when performance was measured on the basis of average five-year rolling returns. The average of its 12 five-year rolling returns was 13.01%, compared with 11.63% for the market cap-weighted SPX. Differences in the volatility of five-year rolling returns highly favored SPXEW. Big advantage SPXEW.
The final portion of the table displays returns over sequential four-year periods: 1990 to 1993, 1994 to 1997, 1998 to 2001 and 2002 to 2005. The SPXEW demonstrated significantly higher four-year annualized returns in three of the four periods, particularly during the most recent two.
Based on the past 16 years' performance, the SPXEW clearly is a more reliable measure of the broader U.S. equity market. Obviously, it will underperform the SPX when mega-cap stocks are hot. The only downside to the SPXEW is a logistical issue: There is currently only one ETF and one mutual fund available that track it--Rydex S&P Equal Weight ETF and the Morgan Stanley Equal Weighted S&P 500.
EXPENSE ISSUES
Rydex's ETF has an annual expense ratio of 0.40%, while the expense ratio for the Morgan Stanley fund ranges from 0.70% to 1.40% depending on the share class. By comparison, the average expense ratio among the 156 index funds (including multiple share classes) that clone the SPX is 0.58%. If redundant share classes are removed, there are 67 unique SPX tracking index funds with an average expense ratio of 0.37%. However, if the expense ratio is weighted by net assets in each fund, the average expense was 0.17% as of Dec. 31, 2005. It's important to consider that the five largest SPX clone funds possess 68% of all the assets and that their average expense ratio is 0.11%. In other words, the largest SPX clone funds have the lowest expense ratios.
The SPX is the most cloned benchmarked index on the planet. What if the SPXEW were used instead? As shown in "Hard to Beat," below, the impact would be significant. The data in this figure was derived by comparing the performance of 84 actively managed U.S. equity funds that have the SPX as their best-fit index, at least 80% of their portfolios in U.S. stocks and had 10 years of performance history as of Dec. 31, 2005, according to raw data from Morningstar Principia.
From 1996 to 1999, the SPX was a tough benchmark to beat, whereas between 40% to 80% of actively managed funds beat the SPXEW. This is hardly surprising because the performance of mega-cap firms--particularly technology firms--was stunning during the period. For example, at year-end 1999, the average five-year annualized return for the largest U.S. 100 companies (based on outstanding shares) was 36.5%, whereas the average five-year return for all 4,122 U.S. companies was 10.3%.
However, during the six-year period from 2000 to 2005, no more than 30% of actively managed funds beat the SPXEW in any given year, whereas 30% to 80% of the sample of 84 actively managed funds beat the SPX. During this period, equity performance was distributed more evenly across market cap, with mega-cap stocks generally underperforming mid- and small caps. At year-end 2005, for instance, the average five-year return for the largest 100 U.S. companies was -1.04% compared with 6.35% for all 5,288 companies in the Morningstar stock database with a five-year performance history.
Equal weighting makes the SPXEW a better reflection of the performance of the broad U.S. equity market even though it holds the same 500 stocks as the SPX. This is verified by the correlation of 81% between the Equal Weighted Dow Jones Wilshire 5000 Index (EW 5000) with the SPXEW from 1990 to 2005--compared with only a 59% correlation between the EW 5000 and SPX.
The SPX is a relevant benchmark for active large-cap managers who construct and manage their portfolios to mirror the market cap weighting of that index. However, actively managed large-cap funds that aren't trying to reflect the SPX's market cap weighting might more appropriately be benchmarked against the SPXEW.
"All Over the Map," above, shows that many of the so-called SPX clones-the 84 actively managed funds described above-demonstrate significant deviation in portfolio market capitalization and the percentage of the fund allocated to large-cap stocks compared with the Vanguard 500 Index (VFINX), which, with nearly $70 billion in net assets at the end of 2005, is the largest SPX clone fund (shown by the pink dot).
In short, there is evidence that building market cap-weighted portfolios is not the mantra of all active large-cap managers. For them, there's a new index in town.
Craig L. Israelsen, PhD, teaches family finance at Brigham Young University. His email is craig-israelsen@byu.edu.
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