Why It Pays to Own More Than One Index Fund

NEW YORK (TheStreet) -- Seeking to top the S&P 500 and other traditional benchmarks, ETF companies have developed a host of new index funds. While some have been duds, many appear to be winners.

Among the top performers are equal-weight and fundamental funds. Large-cap funds that have outpaced the S&P 500 by a comfortable margin during the past five years include Guggenheim S&P 500 Equal Weight (RSP) and PowerShares FTSE RAFI US 1000 (PRF), a fundamental fund. PowerShares FTSE RAFI US 1500 (PRFZ), a small-cap fundamental fund, outdid the S&P 600 small-cap benchmark.

Should you toss out your old-fashioned index funds? Not necessarily, says Sheldon Jacobs, author of "Investing without Wall Street" (John Wiley & Sons).

Jacobs says that traditional S&P 500 funds have excelled during some periods, while at other times fundamental and equal-weighted strategies have shined. To avoid lagging, he suggests holding a diversified mix that includes several kinds of index funds.

Jacobs notes that the S&P 500 was a star of the 1990s bull market. During the last five years of the decade, the S&P 500 returned 28.6% annually, outdoing most actively managed funds by a wide margin.

The equal-weight ETFs did not exist at the time. But there was a comparable mutual fund, Invesco Equally-Weighted S&P 500 (VADAX). It trailed the S&P 500 by 9 percentage points annually during the 5-year period.

The reason for the benchmark's stellar showing in the 1990s can be traced to its structure. Like most benchmarks, the S&P 500 weights its holdings according to market capitalizations. Under this system, stocks with larger market value carry greater weights.

Apple (AAPL), currently the biggest stock in the S&P 500, accounts for 4.4% of the assets, while car dealer AutoNation (AN) accounts for 0.01%. As a stock rises, the weighting increases.

During the late 1990s, a small number of big technology stocks came to dominate the S&P 500. As they soared, companies such as Microsoft (MSFT) and Cisco Systems (CSCO) came to account for a huge weighting in the benchmark.

By 1999, technology represented 39.6% of the S&P 500. The strong showing by a handful of stocks pulled the index to new heights. Then when technology crashed in 2000, the former stars pulled the benchmark down hard. Today technology is 18.3% of the benchmark.

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