The S&P Alternatives

By Aaron Levitt | January 15, 2010 AAA

In the world of investing, nothing is as tried and true as index fund investing. Investing in an index mutual fund or ETF is a form of passive investing. The primary advantage to such a strategy is the lower management expense ratio on an index fund and the ability to "buy the market" with one ticker or fund. Most of the money tied to index funds tracks the broad S&P 500; $77 billion alone is located in iShares S&P 500 Index (NYSE:IVV) and the SPDRS S&P 500 (NYSE: SPY). The index is comprised of 500 of the largest stocks listed in the U.S. plus a few international ones. The index includes stocks across all sectors of the economy has a weighted average market capitalization of approximately $80 billion.

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The Lost Decade
For over 200 years of recorded stock market data, no decade had such a poor performance as the 2000s. Since the end of 1999, stocks on the New York Stock Exchange have lost an average of 0.5% a year during this decade, squeaking past the 0.2% decline stocks suffered during the Depression years of the 1930s. The S&P 500 finished nearly 37% down during 2008's major crisis, and regained about 23% in 2009. Almost every asset class from gold to U.S Treasury bonds has performed better. While the broad stock measure has started to regain some of its former glory, index investors are perplexed as to what the future holds.

Some S&P Alternatives
Index investors need not fret. While the SPDR and the iShares funds are two of the most popular ways to play the S&P, there are other opportunities. And these S&P clones have beaten the standard index by more than a few percentage points in the past year, while following the same basket of stocks. The trick is how the ETFs weight the indexes constituents.

The Rydex S&P Equal Weight (NYSE: RSP) holds all 500 stocks in the index, but weights them equally as opposed to market cap. Each stock is given a 0.20% weighting in the fund. This causes RSP's top 10 holdings to account for 2.5% of total holdings. SPY's 10 biggest allotments are about 20%. Setting each stock on the same footing, the index prevents overweighting overvalued stocks and underweight undervalued ones. For the year ending 2009, RSP achieved a return of 45%.

Smaller ETF provider RevenueShares uses top-line revenue instead of market cap to determine the index's weighting. The RevenueShares Large Cap (NYSE: RWL) stresses companies with a low price-to-sales ratio and underweights those with higher numbers. Wal-Mart (NYSE: WMT) takes precedence in the fund as the top holding. RWL outperformed the S&P by nearly 7% percentage points in 2009.

At its very basic, a buy-write or covered call strategy is where the investor buys a stock or a basket of stocks and writes call options that cover the stock position. The advantage is that the option premium cushions the downside in the event of a falling stock price. PowerShares S&P 500 Buy Write ETF (NYSE: PBP) makes using such an approach easy for investors. Since the fund's inception, it has outperformed the broad index by 4%.

Bottom Line
Index investing is a great strategy for building a portfolio. While the broad S&P 500 has performed dismally in the last decade, applying a different methodology to the underlying basket of companies is proving profitable. Investors may want to think about adding these "alternative" S&P ETFs to their portfolios as a hedge or replacing their index allocations all together. (To learn more, see our Index Investing Tutorial.)

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