If you use the S&P 500 as a proxy for the stock market, you’re likely bummed out: The index since the end of 2000 is under water, leading to the natural conclusion that this has been a lost decade for stocks.
Dreams of a wealthy retirement and mingling with the 1 per cent might seem like a long way off.
But while the S&P 500 is the world’s most important equity index and the benchmark that many mutual fund managers strive to beat, it might not provide the best reflection of market activity.
At least one other method of slicing and dicing the market shows that the past 10 years have actually been okay – and it suggests that index investors might be well-served by steering clear of traditional index products.
“The traditional market cap index is a good benchmark, but it’s a bad construct for investing,” said Som Seif, president and chief executive of Claymore Investments.
The S&P 500 weights stocks based on market capitalization, which is the value of all outstanding shares. Behemoths such as Exxon Mobil Corp. XOM-N, Apple Inc. AAPL-Q, International Business Machines Corp. IBM-N and Wal-Mart Stores Inc. WMT-N take up a lot of room in the index, while smaller companies have relatively little influence.
Looked at this way, the index has fallen nearly 5 per cent over the past decade, making it look very lost indeed.
However, if you weight stocks equally – with a high-flyer such as FLIR Systems Inc. FLIR-Q gaining as much influence as General Electric Co. GE-N, whose market capitalization is nearly 50-times larger – then the index’s performance looks very different: It has risen 53 per cent over the past 10 years and hit a record high in May.
This is more than just an exercise in number-crunching.
It means that for many investors – at least those who don’t take the size of companies into account when structuring their portfolios – the past decade has delivered meaningful returns.
More importantly, it also suggests that there might be another way to play the stock market over the next decade, especially for investors who like to track indexes with mutual funds or exchange-traded funds.
To be sure, equal-weighted measures of index performance have been given a boost from small-cap stocks, which have been on a tear recently. The Russell 2000 index, for example, is up 53 per cent over the past 10 years.
But some observers believe that equal-weighted indexes have sound theory behind them too. That’s because they get around what they see as a flaw in traditional indexes.
With market-cap weighted indexes, there is a strong connection between price and weight. That is, any stock that has risen a lot will have a bigger weight in the index. That can lead to setbacks, particularly when bubble-like runups come to an end.
“Any way you can eliminate that flaw is a positive thing,” Mr. Seif said.
Not everyone would agree, of course. After all, who’s going to complain about Apple’s 5,000 per cent gain over the past 10 years? Apple has done well in 2011 as well, which helped the market-cap weighted S&P 500 beat its equal-weighted cousin by about two percentage points this year.
Still, the results of the past decade are seductive, and there are a number of choices for investors who want to get around market-cap weighted indexes.
Claymore has a series of ETFs that weight stocks on factors such as dividends, free cash flow and book value. Bank of Montreal offers equal-weighted ETFs that track segments of the market, such as real estate investment trusts and U.S. banks.
And the Rydex S&P 500 Equal Weight ETF gives the same weighting to each of its 500 members. As some stocks rise and others fall, the index is rebalanced, providing yet another benefit.
Since it increases holdings of out-of-favour stocks and trims outperforming stocks every quarter, it forces investors to buy low and sell high.
Follow David Berman on Twitter @marketblog
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