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By Samuel Lee

Since inception this fund has outpaced the market-weighted S&P 500. Equal-weighting's boosters claim the strategy beats the market by eliminating market-weighting's growth bias. However, researchers have found that equal-weighting has generated almost all its excess return by tilting to mid-cap stocks and a tiny bit to value stocks. Overlaying Vanguard Mid-Cap ETF's (VO) price chart on Rydex S&P 500 Equal Weight's (RSP) chart shows almost identical performance. But VO pulls away when dividends are counted, owing to its lower fees.

To see why an equal-weighted S&P 500 would behave like a mid-cap index, consider how equal-weighting redistributes stock risk. As of the end of August, the S&P 500's largest holding was Exxon Mobil (XOM), with a $360 billion market cap; its smallest, AK Steel (AKS), has a market cap just a hair under $1 billion--well into small-cap territory. With RSP equally weighting both stocks, one might be tempted to conclude that both matter equally to the ETF's performance. However, the small-cap AKS moves much more violently than stodgy XOM, amplifying the smaller firm's influence. In a similar manner, the other small- and mid-cap stocks' volatilities come to dominate the equal-weight strategy's performance.

This means that RSP is essentially a mid-cap fund and can fulfill all the same functions as such. But it'll cost you quite a bit.

Fundamental View
The rich world looks poised for another recession. Yet the U.S. stock market is unattractively valued compared with its historical average. In order to combat depressed consumer demand, rich-world central banks have driven down real interest rates to punishingly low levels, inflating asset prices. The S&P 500 yields around 2% and historically has grown real per-share dividends by about 1% to 2% annualized. If you add in share buybacks, a hidden boost to yield, equity investors are facing a prospective long-run 4% to 5% real return. To compound low expected returns, longer-term challenges are cresting over the horizon.

Investors should also consider several issues afflicting the rich world over the medium and long terms: deleveraging, debt, and demographics. Consumers and banks are busy winding down debts, or deleveraging, at the same time; the result is a balance-sheet recession. Low demand means businesses will have a hard time growing their profits, while governments take in less revenue and run deficits. The growing government debt load presages higher taxes for everyone, meaning, again, lower earnings for investors. Rich-world governments are also burdened with massive health-care liabilities. This is new territory; the world has never promised so much money to future generations while simultaneously experiencing a steep, coordinated decline in the ratio of workers to retirees.

The demographic headwinds introduce two major sources of uncertainty. One is the upward pressure on the equity-risk premium, or the reward investors demand for taking on stock risk. As investors age, they become more risk-averse, meaning they'll demand higher future expected returns from risk assets. This will pressure equity prices down in order to bring their yields up to acceptable levels.

The second risk is the macroeconomic uncertainty introduced by the rich world's policy response to the staggering promises they've made to the elderly.

The picture isn't pretty for the stock market's long-term returns. This doesn't mean investors should dump stocks. Market-timing is a sucker's game. The market will oscillate greatly around the long-term expected return. A more suitable response is to plan for lower long-run returns, cut fees when possible, and not be surprised by volatility.

Portfolio Construction
This fund tracks the S&P 500 Equal Weight Index, whose holdings are identical to the S&P 500's but equally weighted. The fund's quarterly rebalancing brings back each stock to a 0.20% weight. For the most part, equal-weighting doesn't seem to result in extreme sector bets, but the fund has drifted into the value side in the past.

Fees
Rydex S&P 500 Equal Weight levies a 0.40% expense ratio, steep for a mid-cap fund. Since its 2003 inception until the end of 2010, the fund lagged its benchmark by 0.64% annualized, suggesting trading costs ate away 0.24% of assets annually. Quarterly rebalancing amplifies the fund's turnover. The most efficient index funds lag their benchmarks by less than their fees, as they recover some expenses through securities lending. RSP doesn't engage in securities lending, closing that income stream to investors.

Alternatives
The best alternative to RSP is VO, charging a thin 0.12% expense ratio. VO's underlying index, the MSCI US Mid Cap 450, has tracked the S&P 500 Equal Weight Index since 1992. However, VO pays less to track its benchmark. We wouldn't be surprised to see it beat RSP by 0.40% annualized or more in the next decade.

Other mid-cap funds aren't great substitutes for RSP because they own smaller stocks. However, they're still worth considering, especially if they fit well with your current holdings. Schwab U.S. Mid-Cap ETF (SCHM) charges only 0.13% of assets every year, but it's much smaller than VO and thus has poorer secondary-market liquidity.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

Source: Spotlight On Rydex S&P 500 Equal Weight ETF