SPY vs. RSP: Market Cap Versus Equal Weight ETFs

Includes: RSP, SPY
by: Herb Morgan

Herb Morgan (Efficient Market Advisors, LLC) submits: Last year the $1.3 billion Rydex S&P 500 Equal Weight Fund (NYSEARCA:RSP) gained 6.78%. The predominant large cap ETF of choice, State Street Global Advisors' S&P Depositary Receipts (NYSEARCA:SPY), returned 4.78%, underperforming its equal-weighted S&P 500 cousin. This occurred despite SPY’s significant cost advantage (SPY’s expense ratio is .11% vs. the hefty .4% for RSP). Is this simply normal statistical variation or is there something more?

I have taken the opportunity to estimate the returns of the S&P500 and the cap weighted S&P500 while simulating annual expenses of .11% and .40% respectively:

One might come to the conclusion after reviewing such data that the extra .15% per year makes a strong performance case for the RSP over SPY. However investors would be well served to consider additional data before hiking their expenses by nearly 300% in 2006.

More Factors to Consider

Fifeen basis points of incremental return may add up over a thirty year time horizon, but with incremental return comes incremental risk. One should consider the following additional data before committing to the cap weighted strategy.

Market Cap: To be certain the S&P500 is a large or even mega cap index with an average weighted market capitalization of $87 billion, while the weighted market capitalization of the equal weight index is $23 billion. It would make complete sense to figure the RSP to out perform when Mid Cap makes a run as it has in recent years. Many investment officers including myself are looking for large cap out performance in 2006 rendering SPY a better choice.

Volatility: If we add a standard deviation column to our above performance data we find that the equal weight SP500 carries a standard deviation of 17.68% compared to the cap weight version of 15.14%. Over time, this volatility may be less desirable given the very modest pickup in return.

Value: Looking at various valuation measures might further make the case for SPY over RSP in 2006:

In summary, the equal weight index is quite different than the cap weight alternative rendering a pure large cap comparison somewhat lacking. RSP will have its place in the large cap segment of our portfolios from time to time as conditions permit. For 2006, however, my money is on SPY.

Herb Morgan is president and Chief Investment Officer of Efficient Market Advisors, LLC (www.etfaccount.com) a Registered Investment Advisor catering to high net worth individuals and institutions. EMA is also an available manager through the Wrap Manager dot com platform. (www.wrapmanager.com)