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John Reese is chief executive officer of Validea.com and Validea Capital, and portfolio manager for the National Bank Consensus funds. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service. Try it.

At a time when the Standard & Poor's 500 index is beating records on a regular basis and most professional managers are underperforming it, it might seem impossible to beat the benchmark merely by holding the same exact stocks within it. But long-term data suggest you can beat the market by doing exactly that.

As its name suggests, the S&P 500 holds 500 stocks, but each is held in proportion to its market capitalization. That makes it skewed toward large companies, such as technology giant Apple and the energy stalwart Exxon Mobil.

But some funds track an index that holds each component of the S&P 500 at an equal weighting, not favouring big companies over others. And this causes a significantly different weighting of securities, one that gives a mid-cap regional bank such as Zions Bancorp equal footing to a telecommunications giant such as AT&T.

Since it began in 2003 through mid-December, 2016, the Guggenheim S&P 500 Equal Weight exchange-traded fund, which tracks this different measurement, is up 246 per cent versus a 145-per-cent gain for the SPDR S&P 500 ETF Trust, the fund that tracks the standard market-cap-weighted benchmark. This means a $1,000,000 (U.S.) investment would be worth $3.4-million if invested in the equally weighted fund compared with $2.5-million in the S&P.

If you are a diehard passive investor who thinks market-cap weighted indexing is the only way to win, I am guessing I got your attention.

The equal-weight strategy covers for a few flaws in the market-cap style. It keeps the investor from overinvesting in hot, expensive and overbought stocks. And it reduces the risk of overexposure to a handful of stocks because it doesn't invest according to market-weights.

Apple and Microsoft alone make up more than 5 per cent of the standard S&P index, and technology stocks in general make up nearly 20 per cent. Together, those two tech giants don't make up more than half of 1 per cent of the equally weighted index, which has less concentration to technology and more to financial services.

And because the equal-weight index is rebalanced every quarter to maintain its underlying stock mix, the index methodology has a systematic mechanism that results in funds being allocated to stocks that have sold off, effectively bringing them back to equal weight, and taking money off the table of the stocks that have gone up.

Often the smaller the stock, the more risky the shares may be. This proves out, but only to a small extent, in the risk numbers when comparing the equal weight S&P fund with the market-cap weighted one. Over the past 10 years, the equally weighted S&P fund has exhibited slightly higher volatility. In 2008, the equally weighted fund lost more than 40 per cent compared with a decline of 38.6 per cent for the market-cap-weighted S&P fund, but in 2009 the equally weighted fund was up more than 44 per cent compared with 26.3 per cent for the regular S&P 500.

There are times, however, when the leadership in the market gets very narrow, a problem for an equal-weighted fund. In 2015, the acronym FANG – which stands for Facebook, Amazon, Netflix and Google – got popular mostly because it was these few stocks that were driving most of the returns in indexes such as the S&P 500 and Nasdaq. When the leadership in the market narrows, and the largest stocks are doing best, an equally weighted portfolio is likely to struggle.

However, because of that, you get rewarded on the back side when the average stock starts to perform much better. For instance, in 2016, the equally weighted fund is up 16 per cent year-to-date versus 13.4 per cent for the S&P market-cap weighted fund.

Investors who want a rules-based approach to passive investing and understand the downside to market cap weightings, but want to beat the S&P 500 at its own game, might want to consider an equally weighted approach.

Taking the concept a step further, funds have begun to emerge who use long-term data to weight the index, and the initial results are promising there as well. For example, it has been proven over time that small stocks outperform large ones and that value stocks that trade at discounts relative to things like earnings, book value and sales, outperform the market in general. So using that data, the S&P 500 can be ranked according to relative value, dividends and other fundamentals in order to weight the stocks that data suggest will outperform more heavily over the long term.

To further that concept, I used my quantitative system to rank and score the stocks in the S&P 500 and see what might be weighted the most heavily now based on fundamentals, and how that compares with the current weighting. As of this writing, the table below shows the top 10 stocks based on their fundamental attractiveness using the strategies of Warren Buffett, Peter Lynch, Benjamin Graham and numerous other quantitative models based on legendary investors. The table shows our ranking along with each stock's weighting in the SPDR S&P 500 ETF Trust, which is based on the S&P 500 index.

Further screening stocks based on how they stack up using earnings, valuations, price momentum, cash flow and dividends offer another way investors can look at reweighting popular indexes in order to drive long-term returns.

Fundamentally attractive

Fundamental Attractiveness RankCompanyTickerWeight in S&P 500 (market-cap weighted)
1Valero Energy Corp.VLO-N0.16%
2Pepsico Inc.PEP-N0.77%
3Robert Half Int'l Inc.RHI-N0.03%
4Apple Inc.AAPL-Q3.18%
5Clorox Co.CLX-N0.07%
6Foot Locker Inc.FL-N0.04%
7Tyson Foods Inc.TSN-N0.09%
8Signet Jewelers Ltd.SIG-N0.03%
9Michael Kors Holdings Ltd.KORS-N0.03%
10Alliance Data Systems Corp.ADS-N0.07%

Source: John Reese

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