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S&P Fund Tops the S&P 500

NEW YORK ( TheStreet ) -- Long-term shareholders of S&P 500 funds have reason to be satisfied. During the past 10 years, SPDR S&P 500 ETF returned 7.8% annually. But investors could have gotten richer results with Guggenheim S&P 500 Equal Weight , which returned 10.6% annually.

As the name suggests, Guggenheim puts an equal amount of assets in each of the 500 stocks. Can the equal-weight fund top the traditional S&P 500 during the next decade? Probably. Under a variety of market conditions, the equal-weight fund has some key advantages over standard competitors.

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Like most benchmarks, the traditional S&P 500 is weighted by market capitalization. So a stock with the greatest market value carries the heaviest weight. Exxon Mobil , the biggest stock in the benchmark, accounts for 2.8% of the assets in an S&P 500 index fund. The smallest holdings, such as Big Lots , account for 0.01%.

Many academics have long argued that market-cap weighting is the most efficient way to operate index funds. But there are notable problems with traditional benchmarks. When markets become overheated, the most popular stocks can account for an outsized percentage of assets. That exposes investors to significant risks.

During the Internet bubble, the technology component of the S&P 500 soared from 13% of assets in 1998 to 33% in March 2000. A handful of mega-cap names -- including Microsoft and Cisco Systems -- accounted for a sizable percentage of assets. When technology crashed, investors in index funds suffered painful losses.

To avoid placing big bets on individual stocks and sectors, more investors have begun gravitating to equal-weight benchmarks. The Guggenheim fund puts 0.20% of assets in each of the S&P 500 stocks. Every quarter, the portfolio rebalances, selling off appreciated shares to bring weightings back in line. The value of steering away from hot shares became clear when the Internet bubble burst in 2000. For the year, the S&P 500 lost 9.1%, while the S&P 500 equal-weight benchmark gained 9.6%.

Because it does not overweight the biggest shares, Guggenheim has a greater emphasis on the smaller stocks in the S&P 500. Many studies have shown that smaller stocks outdo larger ones over the long-term. In recent decades, the mega caps have trailed smaller names, providing a big edge for the equal-weight approach.

During the past decade, the equal-weight benchmark has done particularly well in bull markets. At such times, investors have shown a greater appetite for riskier small stocks and less desire to take shelter in the biggest names. When stocks rebounded in 2009, Guggenheim returned 44.6%, compared to 26.4% for SPDR S&P 500.

While they may deliver greater returns, smaller stocks can be more volatile. That has sometimes resulted in poorer performance for the equal-weight fund. But most often, equal-weight portfolios have held their own in down months. During the 20 years ended in 2012, the equal-weight benchmark returned 10.2% annually, compared to 8.2% for the conventional S&P 500.

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The equal-weight benchmark does trail during the times when mega caps lead the markets. That happened in the great technology bull market of the 1990s.

For the six consecutive years ended in 1999, the S&P 500 outdid the equal-weight index. Then beginning in 2000, the equal-weight index outperformed for six consecutive years.

The mega-cap periods of outperformance are relatively rare, says Craig Lazzara, senior director of S&P Dow Jones Indices. "It is typically the case that the largest stocks are not the market leaders," says Lazzara.

While the long-term odds may favor equal-weight funds, some analysts argue that the mega caps are due for a period of outperformance. Todd Rosenbluth, director of ETF research for S&P Capital IQ, argues that the Guggenheim fund can be a solid core holding. But he prefers SPDR S&P 500, because of its big stakes in the blue chips, including Chevron General Electric , and Microsoft. "The mega-cap stocks are attractively valued," he says.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

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