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New Fund Puts S&P 500 Stocks on Equal Footing

The Rydex ETF assigns the stocks an equal weighting, putting smaller companies on par with larger ones.

Like many trendsetters, Charles Dow probably didn't quite realize what he was on to when he first published a list of the closing prices of 12 stocks in The Wall Street Journal in 1896.

Now, 100 years and several hundred indices later, Dow's original intent -- to represent the economic strength of the country -- has been reinvented, rejiggered, licensed and marketed for a variety of reasons. Newest on the scene is the equal-weighted

S&P 500

index, which venerable indexing giant Standard & Poors has created at the behest of Rydex Funds, which produced an exchange-traded fund based on the index. The new ETF begins trading today on the

American Stock Exchange

under the symbol RSP.

"In some cases, equal weighting is the simplest and most straightforward way of indexing," says Chuck Tennes, portfolio director at Rydex, who adds that it minimizes overweighting in different sectors. "These funds are just modules to be used in building a risk-adjusted portfolio for investors."

Variations on a Theme

The equal-weighted S&P 500 ETF is the latest in a long line of variations on an indexing theme. Later indices, like the S&P 500 and the Wilshire 5000, were expanded versions of Dow's original one, and more accurately track the market. Now, though, investment banks and the exchanges themselves can create an index to reflect pretty much whatever they want -- and then license the use of the index to mutual funds and portfolio managers who want to base their products on it. Also, options, futures and other derivatives can be traded based on an index.

There's no alchemy in the process: Stock indices are simply a composite of equities with similar characteristics, such as size or sector, whose changes are measured from a base period. The base date and base value, determined when creating the index, are fairly arbitrary. Each index operates according to its own set of rules that dictate, among other issues, how often the component stocks get re-evaluated (which could be every two weeks or whenever the urge strikes) and how the component equities and their movements affect the level of the index.

A price-weighted index, like the

Dow

, measures the change in the prices of the component stocks. Price is the only variable, and higher-priced stocks dominate the index. That's why if

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shares surge, so will the Dow.

Capitalization-weighted indices, like the S&P 500, measure change in market value. While higher capitalized stocks will move the index more, these indices are more indicative of the value of the component stocks.

Equal-dollar-weighted indices are designed to ensure that all index components have an equal weighting at the base period. That way, a 5% change in a high-priced stock has the same affect on the index as a 5% change in a low-priced stock.

"We thought about creating an equal-weighted S&P 500 index even before Rydex approached us," says David Blitzer, managing director and chair of Standard & Poor's index committee. "But it's easier to do when you have a real-life client who feels there's a market for it and is ready to license it."

Index Investing Isn't Always Conservative Investing

The advantage to investing in a product (be it an ETF or a mutual fund) that's based on the S&P 500 is that you truly are investing in the market as a whole. The 500 largest stocks included in the S&P 500 make up 80% of the U.S. stock market capitalization. "If you track 80% of something, you really have it covered," Blitzer says.

But therein lies the problem, according to some investors. The top 10 stocks in the S&P 500 make up 24.3% of the index's total capitalization. The top 40 stocks make up just over 50%. That means that 460 stocks represent the remaining half of the index's market value. While that's fine if you want to own and track the market, it's not so fine for more sophisticated investors looking to capitalize on any run up in small stocks, or who want to hedge their large-cap bets.

"It occurred to us at Rydex that capitalization weighting in an index serves investors well in a run up, but has a less pronounced advantage in a sideways market like we're in now," says Chuck Tennes, portfolio director at Rydex.

Indeed, the S&P equal-weighted index has outperformed the S&P 500 during the particularly bearish years, losing just 5% in the past three years, as opposed to the S&P 500, which lost 16% in the same period. (Even though the index was just created, Standard & Poor's can assess historical data on how the index would have performed.)

Rydex is not unfamiliar with an offbeat product line. The fund family was the first to offer leveraged index funds, which attempt to combine the predictability and transparency of index funds with hedging techniques that allow fund investors to actually beat the index. "There's nothing wrong with the S&P 500, we have four products based on it," Tennes says. "We're just looking at it through a different window."

Believers in small stocks but who still want the security of investing in large-caps could find the new Rydex ETF appealing, as the equal weighting allows for a bigger bump if small stocks outperform large-caps.

"This is an ETF for people who believe in small-caps," Blitzer says. "If you believe in indexing as a way to buy the market -- which is a very valid way of investing -- equal weighting is not the way to achieve that."