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Why It Pays to Own More Than One Index Fund

Critics of the S&P 500 say that cap weighting systematically emphasizes overvalued stocks and shuns undervalued names. That pulls down long-term returns.

To correct the problem, fund companies introduced equal weighting. In an equal-weight S&P 500 fund, each of the 500 stocks accounts for about the same weight. As a result, the portfolio does not emphasis a few giant stocks.

During periods when giants lead the markets, the equal-weight portfolios tend to trail the conventional S&P 500. That happened in the late 1990s.

In this decade, small stocks outpaced large ones, and equal-weight portfolios gained an edge. During the past ten years, Invesco's equal-weight fund returned 9.2% annually, compared to 7.5% for the S&P 500.

Can the equal-weight funds continue excelling? That is hard to know. Many studies have shown that small stocks outdo large ones over the long term.

But large stocks often shine for prolonged periods. It is entirely possible that the S&P 500 will outdo the equal-weight funds for the next five or 10 years.

Fundamental funds take a different approach, weighting stocks according to such factors as total sales and dividends.

Under the system, a company with a low stock price and big sales can account for a heavy weighting. Bank of America (BAC) -- which has huge total sales -- is the fourth biggest holding in PowerShares FTSE RAFI US 1000 fundamental fund and accounts for 2.2% of assets. The bank is the 27th largest holding in the S&P 500 and represents 0.7% of assets.

Because sales and dividends are not as volatile as stock prices, fundamental funds tend to maintain relatively steady holdings and sector allocations. That can result in deviations from cap-weighted benchmarks.

In 2007, the PowerShares fund had 18.7% of its assets in financials, compared to 17.6% for the S&P 500. Then in 2008, financials collapsed, and their weighting in the S&P sank to 13.2%. The weighting in PowerShares actually climbed to 20.1%. This occurred because the sales of companies like Bank of America remained enormous, even though the stock prices fell.

The big financial stake pulled down PowerShares, which lost 40% in 2008, trailing the S&P by 3 percentage points. Then financials rebounded, enabling PowerShares to return 41.7% in 2009, compared to a gain of 26.5% for the S&P.

During the past five years, PowerShares returned 2.8% annually, compared to 2.0% for SPDR S&P 500 ET (SPY), a cap-weighted index fund.

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