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S&P500 Index Battle: Market Cap Vs Equal Weight

|About: Guggenheim S&P 500 Equal Weight ETF (RSP), Includes: SPY

The S&P 500 index is composed of 500 leading companies. Companies are selected for inclusion into the S&P 500 index based on seven criteria. The criteria are:

  • U.S. Company
  • Market Capitalization
  • Public Float
  • Financial Viability
  • Adequate Liquidity & Reasonable Price
  • Sector Representation
  • Company Type

After the constituents of the S&P 500 index are selected, they are weighted by market capitalization. The larger the company, the more it is represented in the S&P 500 index. The inclusion and weighting scheme of the S&P 500 is intended to match the risk and return characteristics of the broader large cap universe.

This weighting scheme by definition favors larger capitalization companies. By selecting a market capitalization based ETF, investors are placing larger "bets" on the larger companies in the index. Investors can purchase low cost S&P 500 ETFs such as SPY. If one prefers to invest equally in the S&P 500 companies without size bias, one can invest in the Rydex S&P 500 Equal Weight ETF, RSP.

Comparison

SPY has an expense ratio of just 0.11%, versus an expense ratio of 0.40% for RSP. The equal weighting methodology of RSP must outperform the market capitalization weighting methodology of SPY by 0.29% to break even with SPY.

Equal weighting versus market capitalization weighting changes sector/industry exposure for these two funds. Below is a breakdown:

Industry

SPY

RSP

Comparison

Consumer Discretionary

11.86%

16.80%

-4.94%

Financials

16.46%

16.61%

-0.15%

Information Technology

17.93%

13.88%

4.05%

Industrials

10.01%

11.79%

-1.78%

Health Care

12.63%

10.64%

1.99%

Consumer Staples

10.84%

8.44%

2.40%

Energy

10.57%

8.42%

2.15%

Utilities

3.38%

6.09%

-2.71%

Materials

3.37%

5.65%

-2.28%

Telecommunication Services

2.93%

1.40%

1.53%

The largest discrepancies are in the consumer discretionary industry, where RSP is overweight 4.94% relative to SPY, and the information technology industry, where RSP is underweight 4.05% relative to SPY. Overall, the industry breakdown is fairly similar between the two funds.

Investors in ETFs often do not analyze the underlying companies that comprise the ETF. In the absence of this analysis, investing in each company equally is preferable to investing more in larger companies. One simply does not know the risk and return profile of each company, so spreading your capital equally between companies will provide an equal amount of exposure to each risky company instead of more exposure to larger, risky companies. If the larger market capitalization companies have a better risk adjusted return than average, SPY will outperform. If not, RSP will outperform. Below is a yearly performance chart of SPY and RSP:

Year

SPY

RSP

Comparison

2013 YTD

17.74%

20.25%

-2.51%

2012

15.99%

17.16%

-1.17%

2011

1.89%

-0.67%

2.56%

2010

15.06%

21.37%

-6.31%

2009

26.37%

44.64%

-18.27%

2008

-36.81%

-40.07%

3.26%

2007

5.14%

0.90%

4.24%

2006

15.84%

15.47%

0.41%

2005

4.83%

7.40%

-2.57%

2004

10.70%

16.49%

-5.79%

SPY has outperformed RSP 4 out of 10 years. The total cumulative return for SPY is 80.70% versus 114.61% for RSP.

When SPY was up over 10%, it underperformed RSP 5 out of 6 years. When SPY was up less than 10% or down, it outperformed RSP 3 out of 4 years. Historically, RSP outperforms SPY in bull markets, and SPY outperforms RSP in bear markets.

Conclusion

When selecting a fund to represent large cap US equities, it is important to scrutinize the makeup of the index. Seemingly small differences can have a major impact on long term performance. Expense ratio, selection/inclusion criteria, and weighting methodology all impact the overall performance of ETFs, even within the same large cap US universe.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.