If you're a fan of exchange-traded funds, then you're also likely a fan of index investing. Most ETFs are built to reflect the performance of an index like the S&P 500, after all. Indeed, the world's most-owned exchange-traded fund is the SPDR S&P 500 ETF Trust meant to mirror the world's best-known market barometer.
What if, however, you're indexing wrong?
The question seems crazy at first. Index investing is the one surefire way to ensure you never underperform the broad market, since you're simply buying and holding a balanced piece of the broad market. It's difficult to do it wrong, right? That's why so many millionaire-minded investors choose it as their portfolio's core, foundational holding.
Under certain circumstances, however, it is possible you're not getting the most you can out of the simple indexing strategy. Here's why -- and what you can do about it.
Not all indexes are built the same
Don't panic if you're already holding a stake in the aforementioned SPDR S&P 500 ETF Trust. You'll be fine. At an average annual return of around 10% per year, regular investments in this fund will still eventually get you to the seven-figure mark.
The next time you've got some idle cash to put to work, though, consider stepping into the similar-but-different Invesco S&P 500 Equal Weight ETF (RSP -0.68%) instead.
Just as the name suggests, this Invesco fund holds equally sized positions in each of the S&P 500's constituents. That's in contrast with the regular S&P 500, which is a cap-weighted index. That is to say, the bigger the company is, the greater its overall impact on the value of the index.
For example, enormous Apple currently accounts for nearly 7% of the S&P 500's total value, whereas much smaller Coca-Cola makes up only about 0.5% of the index. For the Invesco S&P 500 Equal Weight ETF, though, both companies reflect right around 0.2% of the fund's total assets. In equal-weighted indexes, smaller companies make just as much impact on the index's performance as larger companies do, for better or worse.
The structural difference between these two types of ETFs -- and their underlying indexes -- raises a key question. Given that all stocks' performances diverge over time, how does the Invesco fund maintain a 0.2% weighting for each of its holdings?
It's simple, really. The asset manager buys and sells stocks as needed once every quarter to bring the ETF's positions back into their targeted balance. And that ongoing rebalancing can make a world of difference to you.
The S&P 500 isn't nearly as well-balanced as you might expect
You've probably sensed it even if you don't consciously know it. That is, over the course of the past several years the stock market's biggest companies have gotten much, much bigger, while the smaller ones haven't grown nearly as well. Invesco's number-crunching indicates that back in 2017 the market's 10 largest names collectively accounted for a little over 21% of the S&P 500's total value. Today they make up nearly one-third of the index's value, and that proportion is still growing.
There's nothing inherently wrong with this shift toward being top-heavy. After all, the reason you buy and hold index funds in the first place is to participate in the marketwide growth being led by the market's leading stocks at any given time -- whichever stocks those end up being. Mission accomplished.
These past few years, however, are an exception to the norm, posing a risk to investors who have come along for the bullish ride. That's because so many factors that have allowed mega-cap stocks like Apple, Nvidia, and Microsoft to soar -- higher interest rates, an economic slowdown, the advent of artificial intelligence), and more -- no longer apply.
This presents an opportunity for smaller companies to catch up. And it's not like we haven't seen such leadership before, albeit on a less dramatic scale. Since its inception in April of 2003, the Invesco S&P 500 Equal Weight ETF has actually outperformed the SPDR S&P 500 ETF Trust even with the S&P 500's heroic, large-cap-led run-up since early last year.
RSP Total Return Level data by YCharts
Past performance is no guarantee of future results, of course. It's certainly possible that the top-heavy S&P 500 could continue outperforming the Invesco fund and the S&P 500 Equal Weight Index it's based upon.
The cliché warning, however, typically applies to more aggressive and active stock-picking strategies. The performance comparison being made above is rooted in the well-proven investing premise that more balance is better than less balance when the future isn't predictable.
And the future's never truly predictable.
Enough of an edge to matter
Again, don't panic if you're currently holding a fund that mirrors the cap-weighted version of the S&P 500 index. It may not matter much in the end, if it matters at all. There's no need to sell a position, particularly if doing so might be a taxable event.
In this same vein, do know that the Invesco fund's regular quarterly rebalancing creates recurring tax liabilities for positions held outside of tax-deferring retirement accounts. The ETF's annual turnover is on the order of 20% (although its actual capital gains distributions tend to be very, very small). While this may mean a lower tax liability if and when you sell the fund in the future, it can be a nagging nuisance in the meantime.
Still, if you believe index investing is your highest-odds, lowest-risk, and simplest means of becoming a millionaire, this ETF's slight twist on the idea at least lowers your overall risk. It may also deliver above-average returns, getting you to the seven-figure mark a little faster than you would with a slightly different instrument.
Just some food for thought in an environment that's still quite gung-ho about straightforward index investing.
