Rather than just buying a standard low-cost S&P 500 index fund, consider an equal-weighted S&P 500 index fund. Research shows, over time, equal-weighted index funds produce better results.
A typical index fund tracks a certain group of publicly traded companies. An S&P 500 index fund owns the exact 500 companies with the exact same position weighting as those in the S&P 500 Index. Most index funds are market-capitalization-weighted. That means a greater percentage of the money managed by the fund gets invested into the largest companies it owns. That means a market-capitalization-weighted S&P 500 index fund now carries a position in Apple that is 25 times larger than its 100th-largest position General Motors. And there are 400 positions that carry an even smaller weighting than General Motors. With this top-heavy approach, the largest companies have a disproportionate influence on performance. Currently, the top 10 S&P 500 positions represent more than 27% of the index and the smallest positions are so small that they have very little impact on the overall performance of the fund.
An equally weighted index fund is built differently than a standard market-capitalization-weighted fund. Such fund isn’t top- or bottom-heavy. It is perfectly balanced. That means it is much more diversified. In an equally weighted index fund, all of the positions are given the same weighting. and that means Apple is given the same weighting as General Motors and HollyFrontier Corporation. Therefore, all of the holdings have the same impact on total performance, no matter how big or how small the underlying companies are.
Historical data shows that equally weighted index funds perform significantly better. One study, found that over the entire time period starting in 1925, an equally weighted S&P 500 fund would have outperformed by 2.7% per year on average.
Note the difference of a 2.7% annual outperformance over the long term:
1. $10,000 investment that earns 9% annually for 30 years turns into $147,305.
2. $10,000 investment that earns 11.7% annually (so, 2.7% higher) for 30 years turns into $289,399.
That’s the power of compound interest. The data in favour of equal weighting is very convincing.
Sven Franssen