A Different Index Fund

Are all index funds the same?  That depends on the index and how they measure it.  While most indexed mutual funds and ETFs are weighted based on the company’s market capitalization.  In this manner Exxon and Apple would be the largest holdings in an S&P 500 market capitalization weighted fund.  In a fund that tracks the same index it could invest according to a percentage of the stocks that make up the index.  In the case of an S&P 500 index all stocks would be owned in a percentage of 0.2% for each company.  That means the largest company is owned in the same percentage as the smallest one.

If by doing this, you would take advantage of the smaller company’s moves as they grow as compared to a market capitalization approach in an overall view.  This is done mainly by equal weighted funds tend to rebalance their positions on an annual if not quarterly basis.  This may increase the taxes to a degree as the fund will now have capital gains that are passed through to the shareholders.  But it also will enable the fund to sell equities that have outperformed the others and buy the ones that have not performed as well.  This is rebalancing the index and just as in a personal portfolio it will over the long haul increase the returns the fund experiences.

By rebalancing this way a fund that invests in the S&P 500 has gone from a fund that is invested mainly in the five largest companies now is an indexed fund that looks more like a mid-cap fund.  If you go by market capitalization the average market capitalization is around $35 billion and in an equal weighted fund the average market capitalization is closer to a mid-sized company value of $17 billion.  As history has shown us small and middle capitalized companies have outperformed the larger companies in an indexed fund such as the S&P 500.  But these added rewards does come at the cost of slightly higher volatility in the fund as compared to a traditional market capitalized fund.  But over the last 25 years this has been a minimal risk that has returned about an extra 1.7% annualized.  Now that may not seem like much but compound that over 30 years and you can be looking at some large money losses.

As you would expect the equal weighted funds are slightly more expensive than that of a passive funds but still cheaper than an actively managed fund.  While an actively managed fund can cost you anywhere from 1% to 2% an ETF that tracks an index in an equal weighted manner can cost as little as 0.4%.  True a passive index fund can cost as little as 0.1% the extra 1% annualized return over the long term outweighs the costs of the two different funds.  If you do not believe me go into Excel and preform a future value function and compare the returns of an investment over at least 20 to 30 years and see what the difference is between a return of 6% and that of one that is 7%.  Don’t feel like looking I will run the numbers for you.  Say you invest $5,500 in a ROTH IRA for the next 35 years if you are in your mid 20’s and right out of college starting your first job.  In the first case you invested in a passive indexed fund that returns 6% a year and remember from an earlier blog we are making our IRA contributions in the first part of the year.  In this fund you would have an account worth $691,938 after 35 years.  Now you took that extra little bit of risk, paid the extra fees and received the extra 1% that same account would now have $872,245 in it.  See the power of compounding of that simple and little extra 1% a year, it means an extra $180,000 in your retirement account.

Shop around and look for an investment that meets your investing needs and then find the one that charges the least in fees.  But do not compare a fund simply on fees as you need to understand the equities that make up the fund as well.

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