How You Can Build A Better S&P 500

| February 5, 2010 | 0 Comments

It’s no secret ETFs are the fastest growing investment product. Investors have invested more than a trillion dollars in ETF products worldwide.  I don’t care who you are, that’s a lot of money…

According to Investor’s Business Daily, that amount could swell to $1.4 trillion by the end of this year!  That a 40% jump in one year!  Clearly, ETFs have caught on in a big way… and in just a second I’ll let you in on a little secret that can help you choose the right ETF.

One of the most popular ETFs available is SPDR S&P 500, better known simply as SPY.

SPY currently trades at around $110 and has almost $69 billion in assets. And on average, over 200 million shares of SPY change hands every day. And why not, SPY is great way get exposure to 500 US large cap stocks in a single trade.

But is SPY the best way to get exposure to these 500 stocks?

The answer depends on what you’re looking for in an ETF.

SPY, like the S&P 500 index it tracks, is market cap weighted.  Market cap weighting is simply a way to determine how much of each stock will be included in the index and ETF.

Here’s how market cap weighting works.  The market cap for each stock in the S&P 500 is calculated by taking the number of shares outstanding multiplied by the share price.  The weight of the company is determined by dividing the market cap of the company by the total market cap of all 500 companies.

The companies with the highest market caps will be given the highest weight.  Essentially, a market cap weighting will put more money in a few of the largest companies while investing less in the majority of stocks.

Right now the top 20 stocks (about 4% of the companies) in SPY make up more than 32% of the fund.  That means the other 480 stocks are underweighted.

Here’s the problem.  The mega-cap stocks are a big part of the index and they’re the least likely to see a big move in stock price.  This might be a good way to gauge the health of the market, but is it really the best way for you to invest your money?

In my opinion, there’s a better way to build a portfolio of S&P 500 stocks.  It’s the S&P 500 Equal Weight index.

An equal weight index works just like it sounds.  All 500 stocks are given the same weight.  This eliminates the dominance of a few mega-cap stocks and gives the smaller cap stocks a bigger influence.

And surprise, surprise, there’s an ETF built on the S&P 500 Equal Weight index.  It’s the Rydex Equal Weight S&P 500 (RSP).

RSP is a good sized ETF, but it’s tiny compared to SPY.  RSP currently trades at about $38 per share and has about $1.6 billion in assets.  It trades around a million shares a day.

When it comes right down to it, it’s all about which one gets better returns.  As of the end of 2009, the equal weight index has crushed the market cap weight index over the last year.  And it’s also been better over a 3 and 5 year time horizon.

In the last year alone, RSP is up 44.5% while SPY is up 26.5%.  Equal weighting the same stocks instead of market cap weighting them delivered an additional 18% return!

So there’s the secret… the index an ETF is built on can make all the difference in the world.

Make sure the ETF you select is aligned with your investment goals. Remember, bigger isn’t always better.  This just goes to show you – by not following the herd you can increase your returns and build a better S&P 500…

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Category: ETFs

About the Author ()

Corey Williams is the editor of Sector ETF Trader, an investment advisory service focused on profiting from ETFs and the economic cycle. Under Corey’s leadership, the Sector ETF Trader has become one of the most popular and successful ETF advisories around. In addition to his groundbreaking service, Corey is the lead contributor to ETF Trading Research, where he shares his insights about ETFs and financial markets on a daily basis. He’s also a regular contributor to the Dynamic Wealth Report and the editor of one the hottest option trading services around – Elite Option Trader.

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