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Can These Hot Passive ETFs Keep Topping the Benchmarks?

In a recent report, Vanguard pointed to the S&P 500 equal-weight index as an example of a benchmark that is placing a clear bet. The equal-weight system puts about 0.2% of assets in each of the 500 stocks. In effect, the biggest stocks are underweighted, while the smaller stocks have a greater weighting than they receive in the standard benchmark. In the past decade, the equal-weight approach has succeeded because mid-cap stocks have outdone large ones. But there is no guarantee that large stocks will not lead the parade in the coming 10 years.

Besides underweighting large stocks, the equal-weight benchmark also gives limited exposure to the hottest growth stocks, which have high share prices. This results in a bias to value stocks. Many academic studies have shown that value stocks tend to outperform over long periods. But there are often periods of five or ten years when growth leads the markets.
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Like the equal-weight funds, the other smart beta strategies tend to tilt toward small and value stocks. Vanguard concedes that there may be legitimate reasons for investors to tilt portfolios, but the company argues that the smart beta funds can be more expensive than traditional index funds. Investors who want to tilt their portfolios can accomplish the goal with standard mutual funds, says Joel Dickson, a senior investment strategist for Vanguard.

Dickson says that an investor who wants to emphasize midcap stocks could hold an equal-weighted S&P 500 fund or a standard market-cap weighted midcap fund. While both choices have similar characteristics, the midcap fund is a bit more volatile. According to Morningstar, the equal-weight fund has 54% of assets in large-cap stocks and 45% in midcaps. "The equal-weight index is technically a large-cap portfolio, but the behavior is similar to a portfolio of stocks with market caps of $5 billion to $15 billion," says Dickson.

During the past ten years Guggenheim S&P 500 Equal Weight returned 9.3% annually, while Vanguard Mid Cap Index (VMCIX) returned 10.1%. The Vanguard fund charges an expense ratio of 0.08%, compared to 0.40% for the equal-weight fund.

Proponents of the smart beta funds concede that their strategies do tilt to small and value stocks, but they say that equal-weighting and the other approaches have an advantage because of the way they rebalance. Under the equal-weight system, the weighting of each stock must be held constant and rebalanced quarterly. If a stock soars, then the portfolio manager must trim it at the end of the quarter in order to maintain the equal weighting. At the same time, the manager must buy more shares of losing stocks. In effect, the equal-weight index is constantly buying cheap stocks and selling expensive ones. That is a recipe for long-term success, advocates argue.

Will the smart beta choices outdo the traditional benchmarks over the long term? That's impossible to know. But chances are that low-cost ETFs following both approaches will deliver strong returns for patient investors.

At the time of publication the author held no positions in any of the stocks mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.
Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.
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