Index Funds That Can Beat the S&P 500

Another strategy for beating the S&P 500 in recent years has been to own small-cap indexes. Small stocks periodically race ahead of large companies, and that has been the case throughout much of this decade.

Some analysts predict that small stocks will lag in the next several years. Whether or not that proves correct, many studies by Ibbotson Associates and other researchers have shown that small stocks outperform the large ones of the S&P 500 by significant margins over the long term. Some of the best records belong to microcaps, the smallest stocks, which may be defined as having market capitalizations of less than $500 million.

Until recently there were few index funds that held microcaps. It was simply too difficult to track a market that includes about 2,000 tiny companies. But recently ETFs have appeared, including iShares Russell Microcap(IWC Quote) and PowerShares Zacks Micro Cap(PZI Quote). The oldest fund in the field is the open-end (BRSIX Quote)Bridgeway Ultra-Small Company Market, which has returned 12.84% during the past decade, about 10 percentage points ahead of the S&P 500.

Bridgeway's portfolio has an average market capitalization of $338 million, compared to $49.5 billion for the S&P 500. The Bridgeway fund tracks the CRSP Cap-Based Portfolio 10 index, which includes the smallest 10% of companies on the New York Stock Exchange. Because it is difficult to trade every one of the microcaps, Bridgeway holds a cross section of about 500 stocks.

"We try to make sure that our portfolio has the same price-earnings ratio and other characteristics as the index has," says Elena Khoziaeva, a Bridgeway portfolio manager.