Index Funds That Can Beat the S&P 500

Investors in S&P 500 index funds have faced discouraging times.

During the decade ending on July 31, the index produced a meager annual return of 2.91%, according to Morningstar. Plenty of stock and bond funds did better than that. Critics have piled on, claiming that the S&P has become outdated. As evidence, the doubters point to a variety of index funds that have outpaced the S&P 500 in recent years.

Can the competing indexes continue trouncing the S&P by wide margins? Not necessarily. But there are a handful of index funds that seem likely to outdo the S&P over the long term.

Among the most promising are funds tracking a cousin of the S&P 500, the S&P 500 equal-weight index. For the past 18 years, the equal-weight benchmark has outdone its more famous S&P relative by 3 percentage points annually. To track the index, investors who pay loads can use ( VADAX) Morgan Stanley Equally-Weighted S&P 500. A low-cost alternative is Rydex S&P Equal Weight ( RSP), an exchange-traded fund.

The return advantage can be traced to the way that the equal-weighted index is constructed. As the name suggests, each of the 500 stocks in an equal-weight portfolio accounts for about the same percentage of the index. When a stock enters the index, it accounts for 0.20% of assets. If the shares skyrocket, the weighting of the stock can rise to 0.22% or so. But S&P keeps the holdings in line by rebalancing periodically, trimming some shares of overweighted stocks and shifting to underweighted names. Because of rebalancing, the index constantly dumps shares of high-priced winners and allocates more assets to cheap losers.

"The rebalancing is probably an important contributor to the strong performance of the equal-weighted index," says Srikant Dash, head of global research for S&P.

Unlike the equal-weight index, the better-known S&P 500 sells cheap stocks and buys expensive ones. This occurs because the famous S&P benchmark uses market-cap weighting, putting more assets in big stocks than in small ones. The largest stock in the S&P is Exxon Mobil ( XOM), with 3.91% of assets, while a small stock can account for 0.01%.

The danger of market-cap weighting became apparent in the late 1990s when large technology stocks skyrocketed. As prices of Cisco Systems ( CSCO) and Microsoft ( MSFT) soared, the S&P 500 had to shift its holdings, cutting unloved stocks and keeping more shares of the technology stars. When the big names collapsed, the index fell hard. The equal-weight index also dropped -- but not as far as the S&P 500 did. The unloved stocks proved relatively resilient in the downturn and cushioned the equal-weight index.

To own the biggest blue chips in an equal-weight fund, consider ( BRLIX) Bridgeway Blue-Chip 35, which has returned 3.01% during the past decade, outdoing the S&P 500 by a fraction of a point. Bridgeway uses a proprietary selection process that generally includes the 35 stocks with the largest market capitalizations. However, there are some instances when the biggest stocks aren't picked for the fund. Bridgeway avoids tobacco stocks. In addition, the portfolio managers maintain diversification. So if too many energy or technology names are among the top 35 stocks, the proprietary system picks some of the next biggest companies to assemble a diversified group.

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) and PowerShares Zacks Micro Cap ( PZI). The oldest fund in the field is the open-end ( BRSIX) 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.

For investors in taxable accounts, the most likely way to beat the benchmark may be with ( VMCAX) Vanguard Tax-Managed Capital Appreciation, which topped the S&P by a percentage point after taxes during the past decade.

Vanguard Tax-Managed tracks the Russell 1000, a close competitor of the S&P 500. But the Vanguard fund is not technically an index fund. The portfolio managers deviate slightly from their benchmark, using a variety of techniques to lower tax bills. For example, the fund sometimes sells downtrodden stocks, booking the losses, which can be used to offset taxable capital gains. The result is a fund that closely mimics its index while dodging the taxman.

By owning the tax-managed portfolio, shareholders should end up with more money in their pockets than if they had purchased a conventional S&P 500 fund.

Stan Luxenberg is a freelance writer who specializes in mutual funds and investing. He was formerly executive editor of Individual Investor magazine.

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