Index Funds That Can Beat the S&P 500

Investors in S&P 500 index funds have faced discouraging times.

During the decade ending on July 31, the index produced a meager annual return of 2.91%, according to Morningstar. Plenty of stock and bond funds did better than that. Critics have piled on, claiming that the S&P has become outdated. As evidence, the doubters point to a variety of index funds that have outpaced the S&P 500 in recent years.

Can the competing indexes continue trouncing the S&P by wide margins? Not necessarily. But there are a handful of index funds that seem likely to outdo the S&P over the long term.

Among the most promising are funds tracking a cousin of the S&P 500, the S&P 500 equal-weight index. For the past 18 years, the equal-weight benchmark has outdone its more famous S&P relative by 3 percentage points annually. To track the index, investors who pay loads can use (VADAX Quote - Cramer on VADAX - Stock Picks)Morgan Stanley Equally-Weighted S&P 500. A low-cost alternative is Rydex S&P Equal Weight(RSP Quote - Cramer on RSP - Stock Picks), an exchange-traded fund.

The return advantage can be traced to the way that the equal-weighted index is constructed. As the name suggests, each of the 500 stocks in an equal-weight portfolio accounts for about the same percentage of the index. When a stock enters the index, it accounts for 0.20% of assets. If the shares skyrocket, the weighting of the stock can rise to 0.22% or so. But S&P keeps the holdings in line by rebalancing periodically, trimming some shares of overweighted stocks and shifting to underweighted names. Because of rebalancing, the index constantly dumps shares of high-priced winners and allocates more assets to cheap losers.

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