One of the most popular tactics of investing is "indexing," or attempting to invest in a market index through mutual funds. This method of investing was popularized in the 1970s after Vanguard created the first mutual fund that tracks the S&P 500 Index. Now, investors can place their funds in hundreds, if not thousands, of index mutual funds and ETFs. These funds now track not only the major indexes, such as the S&P 500 and Dow Jones Industrial Average, but also minor indexes (as well as foreign indexes), such as the S&P 600 Small Cap Index (IJR) and the NYSE Composite Index (NYC). Still, the index funds that track the 3 major indexes (S&P 500, NASDAQ Comp., Dow Jones Industrial Average) remain the most popular.
Despite the strong performances in 2013 thus far, investors who insist on indexing in the major market indices may be missing opportunities for greater profits. This is the case largely due to the weighting of the major indexes. The S&P 500 and NASDAQ Comp. are value-weighted, meaning that the moves in stocks with the highest market capitalizations are more weighted than movements in stocks with lower market caps. For the NASDAQ Comp., the nation's second largest company, Apple (AAPL), is the largest constituent, and represents the highest weight in the movement of the index (~11.5%). For the S&P 500, Exxon Mobil (XOM) and Apple have the two highest weightings, together representing just over 5% of the index's movement. The next highest weighted companies in both the NASDAQ Comp. and the S&P 500 have less than two-thirds the weight of either or.
The Dow Jones Industrial Average (DJIA) is price weighted, meaning that the highest priced stocks are the most weighted in the index. In this case, it is IBM, which as of July 12th, closed near $192. It represents nearly 10% of the index's movement, and the next most weighted company, Chevron (CVX), only represents just over 6% of the DJIA's movement.
Thus, buying any index fund will give a relatively higher exposure to at least one of these three stocks (AAPL, IBM, XOM). So let's see how they have performed vs. the major market indexes with relative strength charts. In this case, a declining line indicates that the stock is underperforming the index. A rising line means that the stock is outperforming the index. For those who want a more in depth explanation on how to read relative strength charts, click here.
First, the most weighted stock in the DJIA versus the DJIA
Next, the most weighted stock in the S&P 500 versus the S&P 500
Then finally, Apple, the most weighted stock in the NASDAQ Comp. versus the NASDAQ Comp.
So, instead of helping the major indexes push higher, as these highly weighted stocks have in the past, now IBM, XOM, and AAPL are inhibiting them from surging even higher. Thus, investors owning major index funds are likely suffering from the relative underperformance of these very heavily weighted stocks.
A better solution could be in equally-weighted index ETFs, such as the First Trust NASDAQ-100 Equal Weighted ETF (QQEW), which has outperformed the NASDAQ for most of the past 9 months or the Guggenheim S&P 500 Equal Weight ETF (RSP), which has outperformed the weighted S&P 500 for nearly a year.
One of the best pieces of advice for investors, besides the proverbial "buy low, sell high," is to "always avoid holding a laggard." However, index investors are doing just this right now. An equally weighted ETF strategy will offer less firm-specific risk from companies with higher weighting and could also offer better gains in the months ahead.